Part One Notes Part One Test Part Two Notes Part Two Test Part Three Notes Part Three Test Part Four Notes Part Four Test 204 Grades


ECO 204--Part One Notes

NOTE:  I am not currently teaching this class, so much of the material
for ECO 204 is out of date.  I have left the notes on the web site,
however--at least for now.

Welcome to macroeconomics!  The web notes are organized according to the date of the lectures.  As you can see above, the notes (and tests) are divided into four parts--part one is the material on the first exam, part two is the stuff on the second exam and so on.  They expand the lecture outline and they include the yellow chalk items.  The notes are not a substitute for the lectures, but they will help if you missed class or if your mind was wandering to things you perceive as more interesting--which, I guess, could be a number of different things!


Definitions of economics

It's a social science which studies human behavior and employs a scientific method.

Formal definition:  The allocation of scarce and versatile resources among unlimited wants.

There are four classes of productive resources: labor, land, capital and entrepreneurship.
(Entrepreneurship is sometimes not listed separately since it can be considered part of the labor resource.)

Capital does not refer to money--it refers to machines and tools used to produce other goods and services.

Economics may also be defined as the study of choice.

The basic allocation problem

The allocation problem is simple enough--how does an economy determine its resource
allocation?  How many aspirin and how many tractors and how many haircuts--and so on. 
The production possibilities curve is designed to show the nature of the basic resource
allocation issue along with some attendant features and problems involved in allocating
those scarce and versatile resources.

The production possibilities curve

Suppose an economy can produce various combinations of widgets or gidgets and
that, initially, other goods and services are not considered.  This obviously is a
simplifying assumption but, as you saw in class, a production possibilities curve
can be made more realistic later on.  Following are five combinations of widgets
and gidgets that our hypothetical economy can produce per day, given the
quantity and quality
of its resources:

  widgets gidgets
A 10 0
B 9 1
C 7 2
D 4 3
E 0 4

This data can be illustrated by a production possibilities curve:

The curve (and the data) show the maximum outputs of both goods.  Our hypothetical
economy wants to produce some combination of widgets and gidgets that is on the
curve. Producing a combination which lies on the curve is called economic efficiency. 
An economy would have difficulty if it was only producing quantities indicated by
point X.  That would involve unemployed resources.  By doing something different,
economies could produce more widgets and/or gidgets and ending up on the
curve.  Point Y, on the other hand, is unattainable.  If the economy grows through
time, the curve would shift outward and at a later time point Y could become attainable.

A production possibilities curve may seem awfully abstract but they can be useful if,
instead of using about widgets and gidgets, you use defense goods on one axis and
nondefense goods on the other.  Or use manufacturing and services.

Opportunity cost

Opportunity cost is the cost of the best foregone alternative.  

If you want to purchase the latest Red Hot Chili Peppers CD, you will have to forego
purchasing something else--perhaps less pizza.  The cost of the CD is the pizza you forego.

_arrow9a.jpg(This is a very important concept which will come up over and over throughout the course.)

Production possibilities and opportunity cost

Refer to the table above and suppose the hypothetical economy is initially producing 9 widgets and 1 gidget.  (How the economy would have arrived at this decision is explained in subsequent discussions about how markets work.)  Then suppose the economy decides to produce 7 widgets and 2 gidgets.  What is the opportunity cost of producing an additional gidget?  It's the 2 widgets they gave up to secure the additional gidget. Make sure you understand this simple point!

Why is the production possibilities curve bowed outward?

The reason is because of the law of increasing opportunity cost.  Go back to the
preceding paragraph.  The economy had to give up 2 widgets to get 1 more widget. 
What if the economy now wants to produce 3 gidgets.   Notice from the table that the opportunity cost of going from 2 to 3 gidgets is 3 widgets.  So the opportunity cost of additional gidgets gets larger as more gidgets are sought.  If they want 4 gidgets, the opportunity cost of that is 4 widgets.   All economies face this phenomenon of increasing opportunity cost.

The final question is why would there be increasing opportunity costs--why would
you have to give up increasing numbers of widgets to obtain an additional gidget?  The reason is that to produce more gidgets, resources (land, labor, capital and entrepreneurship) have to be moved out of widget production and into gidget production.  Resources are not as good at producing gidgets as they were at producing widgets.  In the United States resources, over time, have switched from farming to health care.  Farmers
are not as good at being physicians as they were at farming! 

Four important concepts

Positive and normative economics

Positive economics deals with scientific cause and effect (e.g. an increase in wages
will increase prices other things equal), while normative economics deals with opinions and value judgments (e.g. the government should lower taxes).  Normative economics is more important in macroeconomics than it is in microeconomics.  There are lots of opinions in macroeconomics.

Ceteris paribus

This is a Latin phrase which means other things equal.   It is especially important in building theories. 
We make a statement like an increase in interest rates will lead to higher household saving--ceteris paribus.   In fact, saving might not increase if interest rates rise, but that's because other things don't always remain equal.  We analyze things one a time ceteris paribus and then learn how to reason about several things at a time.

Unintended effects

Many events have effects quite different from what was envisioned.   A gun buy back program is a classic illustration.  If the price of the guns is set too low, not many will be turned in.  If it's too high, guns will be stolen and then turned in to fetch the nice high price.  Either outcome is an unintended effect.  MANY economic events--especially government policy, involve unintended effects.  Learn to think critically so you can discover unintended effects.

Common economic fallacies

There are two common fallacies involved in economic reasoning.  The first is a cause and effect 
fallacy.  Just because one event follows another chronologically does not necessarily mean the first event caused the second.  If, for example,  stock market prices increase and subsequently unemployment in the economy falls it is not necessarily true that the stock market caused unemployment to fall.  That has to be empirically tested to be substantiated.

The second is the fallacy of composition, which means that what is good for one isn't necessarily good for everyone.  If minimum wages increase, some workers will in fact receive higher wages.  But, as we will see later, some workers will lose their jobs and have zero wages.  It is a fallacy to assume that everyone is better off because minimum wages increased.


Some facts about the U. S. economy

Some, but not all, of this section is in chapter 2 of your text.  It is an overview of some of the economic
characteristics of the U. S. and introduces a few macro terms.

How big is it?

The U. S. produces $13,300 trillion (as of October, 2006).  Written out in full, that amounts to


To put that figure in some perspective, that's about 21 percent of total world output.  We have a
population of only about 4.6 percent of the world's total population.  

The most common measure of output is called gross domestic product (GDP) and it is the total
dollar value of everything produced per year.  It's the market value in dollars of all final goods and
services produced per year.  More details on GDP will be explained later.  

A good measure of a country's standard of living is GDP per capita-that is GDP divided by total
population.  Currently, GDP per capita in the US is about $44,365.  Your suggested text shows a
table with the U.S. having the highest GDP per capita.  Not quite.  Some countries--e.g.. Switzerland
and Luxemburg--have a slightly higher per capita GDP.

In the U.S., GDP has grown about 3.3 percent per year since 1900 while population has grown
about 1.1 percent per year.  Obviously then per capita GDP has grown about 2.2 percent on average. 
In the last several years, however, GDP and GDP per capita have grown at a significantly higher rate
than the historical average.

Why have we done so well?

Because we have a huge amount of capital equipment and a very productive labor force.  Our labor
force can produce large amounts of output per year because they have lots of capital, education
and experience.

Even a simple fork lift goes a long way in making workers more productive and in ensuring a high
standard of living in the United States.  (For those of you who took ECO 203 last semester--sorry--it's
the same stupid graphic!)

What kind of things do we produce?

Gross domestic product can be broken up into four components.  A brief description of these
components is set forth below.  The four components are studied in greater detail later on.

Consumption: all the stuff (goods and services) households buy for their own use.  This
is the largest component of GDP--about 70 percent of it.

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Investment: the production of capital goods--machines and tools.  Don't confuse this with
the financial use of the term investment, which refers to the acquisition of stocks and bonds etc. 
This is about 17 percent of GDP--and that's lower than some other advanced countries  
As we will see later, the investment component also includes business' unsold inventories
and residential construction.  For investment to occur, households must engage in saving--
and, to confuse you a bit, saving means everything spent on stuff other than consumption. More later.

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Government: government purchases of goods and services.  This is about 19 percent of GDP,
but this does not include transfer payments.  Transfer payments are payments made to
individuals from other individuals--social security, unemployment compensation and the like. 
Transfer payments are about half of total federal spending.


Net exports:  the value of exports minus the value of imports. Presently, U.S. net exports
are negative--about 6 percent of GDP.  What does that mean?  Imports, obviously, are
greater than exports.  Is that a problem?  Many think so, but it isn't really.  We'll learn more
about that in the last part of the course.

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Changes in the mix of output

Another way to categorize what we produce is to use a listing frequently used by government
economists in analyzing the economy.  There are five such components--agriculture, construction
and mining, manufacturing (both consumption and investment goods), government and services.

If we look at the proportion of total output in each of these five components in 1900 and at present,
there are some significant changes.  Agriculture, for example, was 37 percent of total output in 1900;
now it is only 2 percent.  Services grew from 22 percent of the total in 1900 to about 59 percent at
present.  And government (of course) also expanded rapidly from 10 to 19 percent of the total. 
Manufacturing declined from 22 percent of the total to about 14 percent.  So when someone says
"Well, we don't manufacture anything any more," you can point out that they are
economic illiterates!

For whom is output produced?

Here we deal with how income is distributed--how rich are the rich and how poor are the poor? 
Income distribution is controversial in any society and we will return to consider this in more detail
in the latter part of the course.  Here we only want to provide a simple overview of income
distribution.  The following table shows income distributed in the United States by quintiles:

Household income
Percent of total
income received
lowest 20 % 4 %
second lowest 20 % 9 %
third lowest 20 % 14%
fourth lowest 20 % 23 %
highest 20 % 50%

As the table shows, the poorest 20 percent of households earn only 4 percent of the nation's
total income.  The richest 20 percent earn 50 percent of the income.   Some think income
should be more equally distributed; others do not.  Often times, poor countries have
greater inequality than we do.

The data on income distribution do not, however, include transfer payments. 
So what are transfer payments?  Often called welfare, a transfer payment
occurs when government taxes some households or individuals and then
redistributes that money to other households or individuals.  If that is
taken into account, income is not as unequally distributed as the table
above suggests.

Income distribution is always controversial.  Some think it should be more equally
distributed on grounds that the present degree of inequality is not equitable. 
Some think it should not be any more equally distributed because those with higher
incomes are more likely to save and invest and do other things that contribute to high
economic growth.  Economic growth, they argue, benefits everyone.  Society always
debates the appropriate degree of inequality.  Economics can not solve the puzzle of
the optimum degree of inequality; that's one of society's important value judgments.

The biggest problem associated with inequality is poverty.  Using the government's
official measure of poverty, about 12.6 percent of the population lives below the
poverty level.  Government has spent tons of money on anti-poverty (transfer payments)
programs, but poverty is still slightly higher than it was in 1978 which was the year of the
lowest poverty level.

Finally, it should be noted that many other countries often have greater inequality than does
the United States.  Often times, poor countries have much greater inequality than we do.


The market system

For the next three classes we review the basics of microeconomics, learning how markets work and learning
about government and the economy.  Macroeconomics has microeconomic foundations and that's why we have
to review them here.

Many of you (about two-thirds) have had microeconomics,
so you may wonder why we review it here.  The reason is that
micro is not prerequisite for macro.  Many nonbusiness students
take one or the other of the principles courses, and we want
them to be able to choose which one.  So, if you've
had micro, relax and enjoy the review.  Besides, you may
have forgotten some of the basics!

One of the basic objectives of microeconomics is to understand how prices are determined.  Prices
determine how resources are allocated--where on a production possibilities curve society will be.  Prices,
in turn, are determined by demand and supply.  Consumers have demands for various goods and services;
producers sense those demands and supply goods and services.  The interaction of demand and supply
determines the price of a good or service.


The demand for an item is defined as a desire plus a willingness and an ability to pay for it. 
How much of something will be demanded depends on its price, consumers' incomes, the
prices of other items, population, tastes and preferences and a bunch of other things. 
We proceed by looking at the relation between quantity demanded and price.  We do this
not because other determinants aren't important, but because price is critical for understanding
resource allocation.  Once we formulate the relation between quantity and price we can easily
discuss other determinants as well.

We developed the "law" of demand which simply states that price and quantity demanded
(per some period of time) are inversely related--ceteris paribusWhen we draw a graph of
a demand function it is negatively sloped.  There can be exceptions to the law of demand--
e.g. certain luxury goods--but we assume for our purposes that all demand curves are
negatively sloped.  The negative slope is partially explained by the income effect,
which says that a lower price is tantamount to a larger income which, in turn, would
suggest that people would be more at a lower price.  There is also a substitution effect,
which says that a lower price causes people to substitute the good under consideration
for other goods.  Our focus is on a market demand curve, not an individual one.  We
are interested in how many units of something will be demanded at various prices by
everyone in the market--not just one individual.

Changes in demand vs. changes in the amount demanded

This point is sometimes very confusing.  An increase in demand means the whole curve shift to the right--more is demanded at every price.  An increase in the amount demanded refers to a movement along a demand curve.  The illustration below shows an increase and a decrease in demand.  

wpe4.jpg (5779 bytes)

Suppose the following was a true-false question on a test:  An increase in price will cause a decrease in demand.  The answer is false.  It would be true if it said " . . . a decrease in the quantity demanded."


Earlier I noted that many things effect the quantity demanded of a good--not just price. 
Suppose there was an increase in income, another of the things that bears on demand. 
In most cases, an increase in income could be shows in the diagram above as an increase
in demand.  With larger incomes, many people would likely purchase more of this good. 
So the diagram above--best called a price demand curve--can be used to analyze changes
in other demand determinants.


Supply is defined as the number of units of an item that will be offered at various prices
by all producers (per some period of time).  Supply depends on the cost of producing the
item, on the number of suppliers, on the price of other goods, on expectations of future
market conditions--and various other factors.   We assume that the quantity supplied as
a function of price for most goods is positively sloped; that higher prices will call forth
a greater supply.  

The same problem exists in talking about changes in supply that we saw above in looking
at demand.  An increase in supply means the whole curve shifts to the right; an increase
in the quantity supplied refers to a movement up a supply curve.   Notice that in the case
of supply we often use the words "up" and "down" to refer to shifts in the supply schedule.

Other supply determinants can be looked at in terms of the supply curve which plots
quantity supplied as a function of price.  If wages increase, for example, the supply
curve would shift upward because, for any given output, the higher wages would
require a higher price. 
Watch the terminology here.  An increase in wages could
be described as the supply curve shifting upward; it could be described as the supply
curve shifting to the left; or it could be described as a decrease in supply.  

Equilibrium conditions for a good or service

A market is in equilibrium when the quantity demanded is exactly equal to the quantity
supplied.  This equality determines both equilibrium price and equilibrium quantity. Markets
are not always in equilibrium, but market forces are always propelling the market toward
its equilibrium.  In some cases this adjustment is relatively quick; in other cases it takes
some time for the equilibrium to be achieved.  To complicate this somewhat, a market
may be finding its equilibrium only to be interrupted by a change in demand or supply
which creates different equilibrium outcomes.

It is important to understand why equilibrium is where demand intersects supply.  Look
carefully at the diagram below:

The equilibrium price is Pe and the equilibrium quantity is Qe.   What if price is above
equilibrium at Pa?  The quantity supplied will be OF and the quantity demanded will be
only OC.  Hence there is an excess supply--producers are producing CF more than
consumers are buying.  Firms would experience rising unsold inventories and would
have to reduce price in order to sell them.   Hence a price of Pa could not persist for
long--the market would force the price down.   If price was below equilibrium at Pb,
there would be excess demand.  Firms would find themselves with a back log of
unfilled orders and would raise price to ration the shortage.  At the equilibrium there
is neither a surplus nor a shortage. 

Shifts in demand and supply

It is very important for your to become skilled at figuring out what happens to equilibrium
conditions when demand and/or supply change.  You will do a lot of this as the course proceeds.

A simple example was illustrated in class.  We showed an increase in demand (remember--
that means the whole curve shifts to the right from D1 to D2).  The result was that both
equilibrium price and equilibrium quantity increase.  An increase in supply resulted in a
decrease in price and an increase in quantity. 
(Make sure you can do these simple shifts!)

What happens if there is an increase in both demand and supply?  Look at the following diagram:

In this case we know that equilibrium quantity increases.  An increase in demand, by itself,
will increase quantity.  An increase in supply, by itself, will also increase quantity.  But the
effect on price is indeterminate.  The increase in demand would, by itself, increase price;
the increase in supply, by itself, would reduce price. To know the effect on price requires
that you know which increase was bigger.  In the above figure, the increase in demand is
bigger so the net effect on price is that it increases.  If the increase in supply had been
bigger than the increase in demand, price would have fallen.


Some applications of demand and supply analysis

Price ceilings

Sometimes governments impose price ceilings, or price controls, establishing a price
below equilibrium.  When this happens, the quantity demanded exceeds the quantity
supplied and a shortage develops.   This leads to the development of so-called "black
markets" where people illegally sell at a price higher than the controlled price.  In some
cases, under the table payments may be made.  Sometimes producers reduce the quality
of the good to compensate for the below equilibrium price.  The market tries to find
its equilibrium in spite of government.  Historically, price controls have never worked well.  
Pressures mount and sooner or later the attempt to mess with market outcomes falls apart
and is abandoned.  The Roman Emperor Diocletian tried price controls a couple of
thousand years ago.  They didn't work then and they haven't worked since then!

Price floors

Sometimes government does the opposite of the above by instituting a price floor, or
price support.  This occurs when government sets a minimum price above equilibrium. 
This is done for some agricultural commodities.  When government does this, the result
is a surplus--quantity supplied exceeds quantity demanded.  What happens to the surplus? 
For the price floor to work, government has to buy the surplus at the minimum price.  What
does government do with the surplus?  They can store it, give it away, sell it to another country--
or perhaps put it into orbit.  The cost of buying the surplus as well as the cost of disposing of
it places a further burden on taxpayers--in addition to the higher price they pay for the commodity.  

Minimum wage laws

Demand and supply analysis can be used to analyze a labor market as well as a product market. 
Instead of labeling the vertical axis "price," now label it as the "price of labor," more commonly
called a wage rate.   Instead of labeling the horizontal axis as "quantity," now label it as the
"quantity of labor" or the level of employment.  There is a downward sloping demand for labor
and an upward sloping supply of labor.  The equilibrium wage rate and the equilibrium level of
employment will be where the demand and supply of labor curves intersect.  

Suppose the particular labor market we are describing is for unskilled labor.  Now suppose
government comes along (as it has for years) and mandates a minimum wage rate above
the equilibrium for unskilled labor.  It's just like a price floor we looked at earlier and
illustrated below:

The equilibrium conditions are shown by the "e" subscripts.  With the minimum wage (shown by wm)
the quantity of unskilled labor supplied exceeds the quantity demanded.  Compared to the
equilibrium conditions, fewer laborers will be employed with the minimum wage.  The quantity
supplied is Qs while the quantity demanded is only Qd.  Hence minimum wages lead to an increase
in unemployment--a classical unintended effect.  (Remember earlier we noted that there are often unintended effects associated with government policies.)  This will happen so long as the
minimum wage is above equilibrium.  If the minimum wage is equal to or less than the equilibrium,
then minimum wage laws would have no effect. 

Rent controls

One final application of demand and supply analysis, and that is looking at rent controls.

This may be a bit of overstatement, but a former chair of the Nobel economics prize committee said that rent controls are the most effective way in the world to destroy cities--more effective, said he, than a hydrogen bomb.

There are about 200 U. S. cities, and in many European cities as well, where local governments
impose rent controls to ensure "affordable" housing for low income families.  These are like price
ceilings we looked at earlier.  Typically a landlord can raise rents ONLY when there is a new tenant. 
In most locales, the rent ceilings apply only to certain areas, not the whole city.  What happens
with rent controls?

  • A housing shortage develops.
  • Black markets develop--under the table payments, required furniture 
    rental, "key money" and other creative devices.

  • Deterioration and abandonment occur because the rental income 
    is not enough to ensure adequate maintenance.

  • Overcrowding occurs.

  • Discrimination may occur.

These are the kinds of effects the chair of the Nobel economics committee looked at
when coming to his startling conclusion about rent controls.   There are also effects in
the nonregulated rental properties market.  Because there is a shortage in the rent
controlled market, there will be an increase in demand for housing in the unregulated
areas.  That leads to an increase in rent in those areas, which benefits landlords and
injures the residents in the unregulated areas.  There's another classic example of an
unintended effect.

The public sector

Sometimes markets don't produce optimal outcomes.  That's called market failure.  When that
happens, we expect government to become involved.  There are six sources of market failure
which lead to the necessity for government intervention.  These are briefly discussed below.

1. Referee

One of the obvious functions of government is to serve as a referee when there
are disputes in the economy. That is essentially the justice system. If you and I have a
contract and either of us thinks the other didnít perform according to the contractís terms,
we can go to a civil court to resolve the dispute. Everyone (or at least almost everyone)
agrees that we must have a judicial system. There is, however, a lot of disagreement as
to how government should discharge this function and as to the extent of judicial remedies.
There certainly seem to be a large number of frivolous litigations.

2. Income redistribution

A market system produces inequality in the distribution of income. We looked briefly at this
early in the course.  Not everyone thinks that government has any business altering the market
determined distribution of income--but most do. There are those families and individuals who
are very poor, and become poor for a variety of reasons. Most of us have humanitarian instincts
that lead us to conclude that government should redistribute income. It should redistribute, put
simply, from the haves to the have nots. Here again, however, there is huge disagreement as
to how government should redistribute income and how much income should be redistributed.
Some think government doesnít do enough while others think government has gone overboard
and does too much redistribution. Then there are disagreements as to what kinds of redistribution
programs work best. We will see later on that many of our current programs donít seem to
accomplish their objectives.

3. Preserving competition

Some people just donít play by the rules as we would like them to. Some firms will attempt to
stifle competition. The result will be higher prices and diminished outputs. Certainly U. S.
economic history is full of firms who attempted to abuse the system. Because of that, government
needs to play a role in preserving competition.

Essentially there are two ways government can discharge this function. One is by enforcing
anti-trust laws--laws which were written to ensure fair play in the economy. Government has
undertaken a lot of trust busting activities, breaking up large firms into smaller ones. Government
broke up Standard Oil in the early 1900s; it broke up the aluminum industry following World War II;
it broke up the long distance telephone industry more recently. The other way government tries to
preserve competition is through government regulations. There are about 128,000 federal
government employees involved in administering a huge spectrum of government regulations.
Regulation is expensive and imposes large costs on businesses. Some think there is way too much government regulation--especially the business community. There is disagreement as to whether government is better off emphasizing anti-trust or regulation.

Here again, as in the first two functions and the remaining three
functions, you see a common theme:  Most agree on the basic
necessity for government economic functions--but there is
considerable disagreement as to how government should discharge
them and as to how much government intervention is appropriate.

4.  Public goods

Some things just couldnít be provided in a private market. The classic example is national
defense. It would be a little difficult (!) for someone to open up a national defense store and
then each of us decides how much national defense we want. Another example is a:

(Thatís a lighthouse.) National defense and a lighthouse are examples of pure public goods. 
So is flood control.  Government provides many goods that are not pure public goods, but
letís look at the nature of pure public goods.  Pure public goods have two characteristics 
First, a pure public good is always consumed jointly.  With flood control, for example, either
the whole valley is protected or no one is.  Second, you can't charge consumers on the basis
of usage.  Someone can benefit from the services of a lighthouse whether they are willing to
pay for it or not.  Those that don't want to pay are called free riders.

Well, government sure provides a Lot of goods that that aren't really public goods. Some
examples include education, the post office, and the Tennessee Valley Authority. Think
about those examples. There may be good reasons for government to provide them anyway,
but comparing what government provides with pure public goods helps us form opinions as
to what government really should provide. So here again the same theme is present--everyone
agrees government should provide some goods and services, but there is disagreement as
to what goods and how many of them.

5.  "Externalities"

An externality is a cost (or benefit) which accrues to someone external to a market transaction.
One of the best examples of an external cost is air or water pollution. The market doesnít force
producers or consumers to include the cost of clean air or clean water in a market exchange.

Clean air or clean water is in the nature of a public good and government must play a role in seeing
that our demand for a better environment is satisfied. There is a lot of disagreement about how little
or how much pollution we will tolerate, and there is a lot of disagreement as to how government
should accomplish this. More about environmental economics comes up later on.

There are also external benefits. Education is an example of an external benefit. If someone
receives an education and, as a result, all of us benefit from having a more educated society we all benefit.  Thatís the basic case for public funding of education.

6.  Stabilization

The final function is the most important for macroeconomics and that is stabilization.  Government
is charged with the responsibility to ensure that the society is on the production possibilities curve,
meaning that all resources are to be employed.  Government is also charged with the responsibility
to prevent inflation, to smooth out business cycles, and to foster economic growth.  As we will see--
once again--there is general agreement that these macroeconomic goals are desirable but there is
a lot of disagreement as to how government should do this.  This is at the core of what we will
shortly be looking at in macroeconomics.


Government expenditure

How much does government spend?

The following table shows how much governments spend in the United States on purchasing goods
and services and what percent this is of gross domestic product:

Level of government Annual spending (in billions of dollars) Percent of GDP
Federal $927 billion 7%
State and local $1594 billion 12 %
TOTAL $2521 billion 19 %

Note that total government purchases are $2,521 trillion which is 19 percent of GDP.  Many are
surprised to learn that state and local governments spend far more then the federal government.
Through time, government spending has grown absolutely but has fallen very slightly as a
percentage of gross domestic product.  In many other countries government spending is an
even greater proportion of GDP than in the United States--e.g. in Croatia government spending
is 30 percent of GDP; in Israel, it's 29 percent; and in the United Kingdom, it's 21 percent.

These data, however, do not include transfer payments.  If transfer payments are included,
the proportion rises from 19 percent of GDP to about 30 percent of GDP.  That too is low
relative to other countries.  Many are surprised to learn that in counties like Italy and France,
government spending is more than half of GDP.  Most of the absolute increases in government
spending are because of increased spending on transfer payments.  In 1950, total government
spending (including transfer payments) was 22 percent of GDP, so there have been considerable
increases in the last half century.

The level of government expenditure is controversial.  Liberals often think the U. S. should
spend more than it does, chiefly on additional transfer payment programs.  Conservatives think
that a level of 30 percent of GDP is too high, even if it is low relative to other countries. 
Conservatives think that level of spending is excessive and diminishes economic freedom.

What do governments spend money for?

The federal government spends 16.2 percent of its total budget (including transfer payments)
on defense--lower than many think.  A total of 64.6 percent is spend on human services, of
which social security is the largest single component.  Interest on the public debt is 6.7 percent
of the total--an item that has significance for us later on.

State governments spend 31 percent of their total spending on welfare and 21 percent on
education.  Local governments spend 43 percent on education. 

Where do governments get their revenues?

Preview This Clip Now!

Mostly from taxes and some from fees and some from borrowing.  We want to survey the main kinds of
taxes governments levy because those are important for macro policy, as we will see later on.

Federal taxes

The largest source of revenue for the federal government is the personal income tax, which
produces about 45 percent of total federal revenue.  There are many controversies about this
tax; we look briefly at two of them.  One is the definition of taxable income.  There is a big
difference between the income an individual earns and the portion of it which is taxable
income--the income against which varying tax rates are applied.  The federal government
excludes some income from the income tax.  It allows people to take a number of deductions,
the largest being interest on a home mortgage.  Then it allows some credits against the
amount of tax--e.g. certain child care expenses.  The income tax regulations are very political
but the result is that taxable income is much smaller than total earned income.

The second controversy is that the tax is progressive.  That means that as one's taxable income
rises, so does the tax rate.  Currently, tax rates go from zero percent to 35 percent.  Another way of
understanding progressive taxation is this:  If you earn twice as much as I do, you will be more than
twice as much income tax.
  It's controversial because some don't think it should be progressive at
all and that it would be better if everyone paid the same tax rate (the so-called flat tax).  Others
think the tax should be more (or less) progressive than it is.

The second largest federal revenue source is the social security tax, which accounts for 40 percent
of federal revenues.

Social security is a pay-as-you-go system.  That means that those who are working pay into the system, and those who are retired receive transfer payments from those working.  Social security is not like a private annuity--it's a transfer payment.

Social security, as noted above, is an entitlement but it is not means tested.  That means benefits
are not related to the incomes (means) of the recipients.  Many think it would be a lot better if it
was related to income.

The other major source of federal revenue is the corporate income tax, which accounts for 7
percent of federal revenue.  The corporate income tax is exceedingly complex and is the source
of employment for thousands of accountants and attorneys.  Its complexity often means that
corporations make decisions based on tax consequences and not on economic considerations. 
The tax involves double taxation.  Corporations pay taxes on their net earnings, a portion of
which are distributed as dividends to shareholders.  Dividends are taxed a second time because
they are included in the federal personal income tax.  Many think this feature is inequitable.

State and local taxes

The largest source of revenue for state governments is the retail sales tax which produces
almost half of the total.  (Many states also have a personal income tax.)  You are familiar
with the retail sales tax.  For items covered by the tax, the amount of the tax is simply
added to the sale.  You buy a sweater for $50 and, if the sales tax rate is 6 percent, you pay
an additional $3.  Unfortunately the sales tax is regressive with respect to income.  That means
people with lower incomes pay a higher percentage of their income on the sales tax than do
people with higher incomes.  Why?  People with lower incomes spend a larger proportion of their
income on goods subject to a sales tax than do wealthy people.  Wealthy people spend a lot on
stocks, bonds and real estate and those things aren't subject to the sales tax. 

Local governments rely on property taxes which constitute 72 percent of their revenue. Property
taxes are also regressive because lower income households spend a larger portion of their income
on housing.  A government study found that a household earning $50,000 pays 2.5 percent of its
income on property taxes, but a household earning $10,000 pays 4.5 percent of its income on
property taxes.  Almost everyone thinks that regressive taxes are a bad idea, but we have
them anyway!

Government decision making

Ideally government decisions would be made on the basis of benefits and costs.  For example, projects
would be evaluated by comparing benefits with costs and those with the largest net benefits would be
undertaken.  That's an easy concept.  Costs are relatively easy to measure, but benefits are not.  How
do you measure the benefits of longer life or a local symphony?  Although government attempts to use
benefit cost analysis, many are made for purely political reasons.  Government intervenes, as we saw
earlier, in an effort to remedy market failure and improve economic outcomes.  Government does this,
but in some cases the cure is worse than the disease.  When government does not improve economic
outcomes, it's called
government failure.  There is a lot of that and that is important to remember
when we look at government macroeconomic policy later on.

Here comes a bad joke about economists:

A grade school teacher was asking students what their parents did for a living. "Tim, you be first. What does your mother do all day?"  "She's a physician," Tim replied.
"That's wonderful. How about you, Amy?"  Amy shyly stood up, scuffed her feet and said, "My father is a mailman."
"Thank you, Amy" said the teacher. "What does your parent do, Billy?"  Billy proudly stood up and announced, "My father plays piano in a whore house."

Quite distraught, the teacher went to Billy's house and confronted his father with what Billy had said.  "Actually," the father said, "I'm an economist--but how do you explain a thing like that to a seven year old?" 


Now we begin the heart of macroeconomics.  To understand the macro economy is as easy (or as confusing) as
understanding the behavior of three important macroeconomic variables.  The three are income, employment
(or unemployment) and the price level.  We have to acquire a pretty thorough understanding of what these
three mean, how they are measured, and some problems with each.
These three variables are, in turn,
determined by the behaviors of four economy wide sectors: households, business firms, government,
and foreign participants.  We begin by exploring income beginning today.  Then we look at employment
and then the price level.

Gross domestic product (GDP)

The most common, but not only, measure of the nation's income (or output) is called gross
domestic product.  To approach an understanding of this concept, we need to look at the circular
flow of economic activity.  (There is a circular flow diagram in most textbooks, but they are
sometimes needlessly confusing.)  Below is a simplified circular flow diagram which omits
government and the foreign sector:

Gross domestic product measures the size of the dollars in the diagram.  It is possible to measure
the dollar flow either from the expenditures side or the receipts side; the two values would be equal. 
The commerce department does both, but the most common way is to measure from the expenditures
side--the dollar value of expenditures on goods and services, or the dollar value of output.  The terms
"income" and "output" are synonymous.  The diagram is simplified because it omits government and
the foreign sector; that will come later.  Note that we measure GDP in dollars, not in physical terms. 
Measuring in dollars allows us to add together oranges, apples and rock concerts.

Here is a formal definition of GDP:

Gross domestic product (GDP) is the final value of all
newly produced goods and services within a nation's
borders, per year.

Now we have to dissect that definition to understand what it means.  First, why is the definition restricted
to only newly produced goods and services?  Why isn't a used car counted?  Why is a previously built
house not included?  The answer is to avoid double counting.  If I bought a new car in 2006, its value
would be included in the GDP for 2006.  If I sell it to you in 2007, it would not be counted again--it was
already counted in 2006.  Output is not higher in 2007 just because I sold you my car.  If we agree to
a price, we are both better off--but society's output (or income) is not affected.  The used car is essentially
a transfer---I give you the car; you give me the money.

What does the "final value" part of the definition mean?  That also is to avoid double counting. 
GDP is called a "value added" concept, meaning we count the value added at each stage of
production.  Shown below is a (very) simplified diagram showing how wheat turns into bread
which consumers then purchase:

Look what's happening.  If you looked at the total expenditure of $2.26, you would have counted the
16Ę four different times!  Look at the last column which is the value added at each stage of production. 
If you sum the value added column, you get $1.00--which is the final value.  So saying GDP measures the
final value is the same thing as saying that GDP is a value added concept.

Gross domestic product vs. gross national product

Another older measure of output is gross national product (GNP).  Sometimes people still quote
GNP.  It reports output using factors of production owned by a country's residents, even if production
took place outside domestic borders.  Gross domestic product says "within a nation's borders,"
and does not include production in other countries.  GNP is about one percent higher than GDP--
so it's no big deal.

Real and nominal GDP

Hopefully you now understand what is meant by GDP and why it is defined the way it is.  Now we
need to make another adjustment to the concept to improve its value as a measure of income
(or output).  We need to adjust the yearly measure of GDP to account for inflation.  Suppose that
in a given year the value of GDP increased 10 percent.  Sounds pretty good.  But suppose prices
also increased 10 percent.  Would we conclude that the economy is better off by 10 percent?  No. 
We would be no better of in terms of what we produced.  The 10 percent increase in GDP is
illusory because it merely reflects rising prices--not real output.  The term nominal GDP means
we are measuring in current dollars not adjusted for inflation.  The term real GDP means we are
adjusting the measure for inflation.

How do we do that?  First we have to have a price index.  That is a weighted average of a market
basket full of typical goods and services purchased by households.  There is a base year and the
average price is given a value of 1.  If the average price went up 5 percent in the next year, the
price index for that year would be 1.05.  (The government multiplies everything by 100 so published
price indexes are 100 in the base year.  In the example above, the price index would be quoted
as 105.)  To get real income, we divide nominal income by the price level.  Nominal income is
also sometimes called "income in current dollars."  (A technical note: the commerce department
doesn't use the price index in just one year.  It uses a moving average of several years and is
called a "chain weighted price adjustment.")  Here is the example done in class:

Year Nominal income Price index Real income
1 $100 1.0 $100
2 $150 1.5 $100
3 $300 2.0 $150
4 $350 2.5 $140

Over the four years, notice that nominal increased 350 percent.  But prices increased 250 percent,
so real income increased 40 percent.  In most, but not all, subsequent discussions of income
(or output) we will be talking in terms of real GDP.

Measurement problems

This discussion has been pretty straight forward, BUT--it's never as simple as it looks.  Measuring
real GDP is problematical.  As we will see, there are also measurement problems with
unemployment and the price level.

GDP does not account for nonmarket activities, although they certainly add value.  The services of
a homemaker are not included.  If I give you some fresh flowers from my garden, that isn't included. 
The commerce department, however, does make estimates of two important nonmarket activities. 
One is the food grown by farmers for their own consumption.  The second is the rental value of
housing occupied by its owner.

There is a fair amount of unreported income.  These are participants in the so-called "underground
economy."  If you pay a neighbor kid for mowing your lawn, that isn't included.  If you have a
person that cleans your house and you pay in cash, that isn't included--unless the house cleaner
reports it, which almost never happens.  Drug dealers' income is not reported.  The University
of Michigan estimates that unreported income is about 9 percent of GDP.

In calculating real GDP we used a price index.  As we will see shortly, the price index also involves
measurement problems.  Finally, there are various statistical problems involved.  So our measure
of real GDP is not perfect, but it is still useful!


Other measures of income and output

GDP is the most common measure of income, but not the only one.  There are several other
measures, derived from GDP, that are used for various purposes. The following table shows
how these four are derived, and also gives data for the third quarter of 2006 so you can see
the magnitudes

Income measure

Amount (in billions)

Gross domestic product $13327
Less: depreciation (1581)
Equals: Net domestic product 11746
Less: indirect business taxes (any tax paid by business other than the corporate income tax and employer's share of social security), corporate income tax, employer's share of social security tax, and corporate retained earnings--and plus transfer payments (792)
Equals: Personal income 10954
Less: personal income taxes (1366)
Equals: Disposable personal income 9588

So what's the importance of all this?  For our purposes, the net domestic product  measure is not important. 
Personal income is the income received by households.  Disposable personal income, as the name implies,
is what households have to spend on whatever they see fit.  Businesses are competing for shares of
disposable personal income.  Aggregate consumption depends on disposable personal income. 
So, for us, GDP and disposable personal income are the significant measures. Note that
disposable income is a little over 70 percent of GDP.

Components of income--expenditures side

Earlier we looked at the components of GDP when we defined consumption, investment, government
and net exports.  We revisit those components, because the components will help us solve some of
the mysteries about the macro economy.  We begin with the following equation:

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

Y is the symbol we use for real output or real income.  (We don't use I, because that's for investment.) 
C stands for consumption, I for investment, G for government, X for exports and IM for imports. 
We review each of these, adding a little more fullness to some of the definitions we did earlier.

Consumption (C) refers to households' purchases of final goods and services.  Goods are
tangible things like bagels, sweaters and automobiles.  Some goods are called durable goods--
they last a long time.  A washing machine is a durable good.  Services are intangibles, e.g.
investment advice, interior decorators and so on.  As we saw earlier, the U. S. produces a
larger proportion of services than it did a century ago.

Investment (I) refers to what business firms spend on new capital goods.  Investment, as
used in GDP accounting, actually refers to gross private domestic investment.  Gross
refers to the fact that depreciation is included.  If depreciation is excluded, the result
would be net investment and that would be consistent with net domestic product.  Private
means that no government investments are included.  Domestic means that international
investment is not included.  Two other things are included.  One is the value of business'
unsold inventories.  A car dealer has an inventory of new cars.  They are produced but not
yet sold to households.  So they are included in the investment category.  The other thing
included is new housing.  Housing is certainly a durable good, but it lasts for so long and
is such a high price item that it seems preferable to include it in investment.  As noted
earlier, and as will be discussed again, investment can come about only if households save
a portion of their incomes.  By saving, we mean nonconsumption.  So another macro
relationship is that Y = C + S, where S stands for saving.

Government (G) refers to what government (all levels added together) spends for goods
and services--missiles, paper, asphalt and so on.  Those transfer payments are not included
in GDP because that would involve double counting.  Transfer payments are literally money
transferred from some individuals to other individuals.  But, if we want the total income
received by households (personal income) transfer payments are added in.

Exports (X) refers to the dollar value of things we produce and sell to parties in foreign
countries.  These are added to GDP because they are a part of what we actually produce. 
Imports (IM) are subtracted from GDP because they represent money we spent on goods
we did not produce.  Net exports is simply (X - IM) and, as noted earlier, can be negative--
and have been negative in recent years for the United States.

Components of income--receipts side

We can also split GDP into some components by looking at the receipts side of the circular flow. 
Although we don't use this as often analytically as we do expenditure components, we need to
indicate briefly receipts components.  The equation expressing these components is as follows:

Y = w + r + i + p

Here the w stands for wages, the payments made for the labor input.  The r stands for rent, the
payments made for the land input.  The i stands for interest, the payments made for the capital
input.  The p stands for profits, essentially the return for entrepreneurship.  These payments
correspond to the four factors of production, or inputs, that we identified earlier.

The equation above is really one where Y stands for national income, not GDP.  If we add
indirect business taxes and depreciation to the sum of w, r, i and p, then we have an expression
for GDP.

GDP and the quality of life

To complete our discussion of GDP, we need to think about what it measures--and, equally as
important, what it does not measure. GDP does not measure the quality of life.  It doesn't
measure negative aspects of the quality of life such as pollution or crime.  Neither does it
measure some positive aspects--e.g. sitting in the sun or attending church.  In other words,
GDP measures
economic welfare but not social welfare.  We can't quantify many of the things
relevant to the quality of life.

Some attempts have been made to measure social welfare.   Your text briefly presents Fordham
University's index of social health, which is based on sixteen indicators.   Some items in it are
economic--e.g. unemployment and weekly earnings. Some are sociological--e.g. child abuse,
teen suicides.  That index concludes that social health deteriorated in the 1970s and was
mostly flat in the 1980s and 1990s.  I cannot vouch for whether the index is any good;
it's just an example of measuring something broader than economic well being.

For measuring economic welfare, the best available is real GDP per capita, although it is
far from a perfect measure.

Answers to Quiz #1--1/22/07--10:00 section

1.    false                  6.  D or E
2.    false                  7.  A
3.    B                        8.  C
4.    B                        9.  C
5.    D                      10.  C

Answers to Quiz #1--1/22/07--1:00 section

1.    true                    6.  A
2.    false                  7.  D or E
3.    D                        8.  B or E
4.    D                        9.  E
5.    C                      10.  B



We now look at the second of the three major macroeconomic variables--unemployment.

The labor force

We begin by inquiring as to how we define the labor force.  It is defined as all those over age 16 either
working for pay or seeking to work for pay.  Many individuals are not part of the labor force--those
retired, young children, homemakers, those in prison and others.  All together, about half of the total
population is in the labor force.  Another interesting piece of data is the labor force participation rate. 
Since 1950, participation rates have increased for females and decreased for males.

Unemployment and the unemployment rate

The definition of unemployment is simple--it's those looking for work but unable to find it.  The
unemployment rate then is the number of people unemployed divided by the labor force, as defined
above.  During the great depression of the early 1930s the unemployment rate was about 25 percent. 
Since the end of World War II, the highest unemployment rate was 10.8 percent in 1982 and the lowest
was 3.4 percent in 1968.  Currently (November, 2006) the rate stood at 4.6 percent.  Minority groups
and less educated people have higher rates of unemployment.  Teenagers, especially minorities,
have very high unemployment rates.  Black teenagers have an unemployment rate in excess of
25 percent.

Economists and policy makers are also interested in the duration of unemployment.  That is, at any
point in time, how many are unemployed only briefly and how many are unemployed for long periods? 
The duration statistics are as follows:

32 percent were unemployed less than 5 weeks.
30 percent were unemployed between 5 and 14 weeks.
16 percent were unemployed between 15 and 26 weeks.
22 percent were unemployed 27 weeks or more.

The median length of unemployment in 2006 was 8.3 weeks.

The effects of unemployment

Why does unemployment matter?  This may be obvious, but there are both adverse macro and micro
effects of unemployment.  From a macro view, unemployment leaves the economy inside its production
possibilities curve.  (Remember that from very early in the course?)  Look below at a production
possibilities curve showing consumption goods on one axis and investment goods on the other:

If the economy is operating at point U, there is unemployment.  If we could move from point U to point X,
the economy could produce more investment goods without giving up any consumption goods.  Moving
from U to Z would mean more consumption goods without giving up any investment goods.  Hence the
important macro effect is that we have less output than we are capable of producing. It is estimated by
some economists that an increase in unemployment of 1 percent leads to a reduction of 2 percent in
total output.

At the micro level, it's simple--people out of work have no income and that's a big problem for any
household.  Other less obvious effects also occur.  Sometimes disease increases because of the
stress of being out of work.  Sometimes suicides occur.  Often, crime rates rise when unemployment

Measuring unemployment

How is unemployment measured?  The Bureau of the Census does it monthly using a sample of 60,000
households.  It is a telephone survey.  They ask whether any member of the household is not working
but is seeking work.  If the answer is yes, that one counts as being unemployed.  They also obtain
demographic data--age, race, etc.

(Some of you may wonder why I put these silly clip art things on the web site. 
Two reasons.  First, to brighten it up!  Second, and more important, they may be
visual cues that will assist you in remembering important concepts and information.)

There are, however, at least three problems with this procedure.  First, there is a response bias.  Some
will say they are looking for work even if they aren't really.  Some on welfare are required to be seeking a
job and they don't want to indicate that they really aren't.  So they say they are!  This is called
phantom unemployment
. The extent of this is not known, but it may mean the reported unemployment
rate is overstated. 

Another problem has to do with discouraged workers.  These are people who really do want to be
employed, but they aren't looking for work because they don't think they will find a job anyway.  They
may think they don't have the skills, or are too old--or whatever.  The existence of discouraged workers
might lead the reported unemployment rate to be too low.

A final concern involves the underemployed.  This refers to one of two things.  First are workers who
work part time but really want to work full time.  Even if someone is working only one hour per week,
they are counted as employed when the census bureau calls.  Second are those working for incomes
less than their skills would indicate--e.g. a college graduate working at burger world.

So how do we interpret the unemployment rate?  The absolute reported level may not be entirely reliable
for the reasons we just saw.  Relative changes, however, are important.  An increase from 5 percent to
7 percent, even if the exact numbers are not accurate, would be a cause for concern.

What is full employment?

When we say one macroeconomic goal is "full employment," what does that mean?  It doesn't mean an
unemployment rate of zero.  There are reasons for believing that zero is not attainable or even desirable. 
To see that, we look at four different types of unemployment.

Seasonal unemployment.  Seasonal unemployment, as its name suggests, refers to those who are
unemployed during certain seasons of the year--e.g. construction workers, workers at ski resorts. 
These are typically not considered problematical because they have earnings during the seasons
they are employed.  In some cases, their annual earnings may be relatively high even though
they experienced some periods of unemployment.

Frictional unemployment.  Frictional unemployment occurs when someone is between jobs, often
looking for a better one.  In part, frictional unemployment reflects a mobile labor force--a
characteristic thought desirable by economists.  

Structural unemployment.  A more problematical type of unemployment is structural unemployment,
which arises from structural changes within the economy.   This occurs when there is a mismatch
of either skills or location between unemployed workers and available jobs.   Technological
advancement often spawns structural unemployment.  Many information technology related jobs
are presently available, but some of the unemployed do not have the skills to land those jobs. 
Many talk about a skills gap.  One government agency estimates that 98 percent of all new
jobs created in the next decade will be service sector jobs.  The text and the government
see this as a source of structural unemployment.  Over time, however, the U. S. labor force
has been very resilient and has responded to many, many changes.

Cyclical unemployment.  A final type of unemployment is cyclical unemployment.  That occurs
when there is a lack of job vacancies during a period of recession.  At times, this has been a
problem; at present it is not.

What IS full employment?

We arbitrarily say that full employment is some low rate of unemployment.  We do this for the reasons
cited above--absolutely zero unemployment can not be attained and is not desirable. Sometimes it is said
that full employment is the lowest level of unemployment consistent with price stability.  That's debatable--
and we will look more at the relation between prices and unemployment later on.

In the 1960s, government officials proclaimed that full employment was an unemployment rate of 4 percent. 
Reagan advisors in the 1980s said an unemployment rate of 6 or 7 percent was full employment.  Bush and
Clinton advisors said it's 5.5 percent.  Since the rate is now 4.6 percent, most think we are essentially at
full employment.



Nature of inflation--and a few facts about it

Inflation is defined as an increase in the average prices of goods and services throughout the economy. 
Relative prices can change without there being inflation.  There can be instances in which some prices
increase while other prices decrease without there being any inflation.  The inflation
rate is simply the
annual percentage increase in average prices.

If we had inflation of 4 percent per year, prices would double in 17.7 years.  But if inflation was 10
percent per year, prices would double in 7.3 years.  That reflects the nature of compounding.  

Historically inflation has always been high following major wars.  This is because of the transition
from war time to peace time production.  During a war there is a shortage of many consumer goods
and, when the war ends, there occur large increases in demand for consumer goods.   Following World
War I inflation was about 20 percent and following World War II about 16 percent.  Inflation in the mid
1970s was over 11 percent and the highest inflation rate since World War II was 13.5 percent in 1980. 
In 1998 the inflation rate was a very low 1.6 percent and in 1999 it was 2.7 percent.  Currently (in the
third quarter of 2006) inflation was 1.3 percent.  Most of you cannot imagine an environment in which
prices rose more than 13 percent in a single year!  The subtitle in the syllabus for today's lecture asked
who had an inflation rate of 23,760 percent.  The answer is Zaire in 1994.  If inflation is over 200
percent it is called hyperinflation.  There was also hyperinflation in Germany following World War II.

It is possible to have deflation.  That would be a fall in average prices.  That happened in the United
States in the 1930s, but has not happened since. 

So what are the consequences of inflation?

Micro consequences of inflation

The chief micro effect of inflation is a redistribution of income and wealth.  This point may
be a little subtle, but it's important.  This redistribution can be explained through price effects,
income effects and wealth effects.

First we consider price effects.  When inflation occurs, some prices typically rise faster
than others.  If a household purchases things whose price has risen rapidly, they will suffer
a loss--the purchasing power of their income falls.  Households which purchase things
whose price has risen slowly (or not at all) will gain.  Hence there is a redistribution of
purchasing power (real income) from those who purchase things with rapidly rising prices
to those who purchase things with slowly rising prices.

Next consider income effects.  Some households experience an increase in their nominal
income faster than the rate of inflation.  (Remember what nominal income is.)  If I have
an increase in my nominal income of eight percent and inflation is five percent, I come
out ahead in terms of an increase in my real income.  If you have an increase in nominal
income of three percent when inflation is five percent, you come out with less real income. 
Hence inflation redistributes real income from you to me.  Those on fixed incomes (
e.g. some retirees) are particularly hard hit by inflation.

Finally there are wealth effects.  Some kinds of assets typically increase in value during
inflation--e.g. stocks and bonds.  Some assets--e.g. farm land or gold--typically lose value
during inflation.  Here again inflation redistributes.  In this case, the real value of wealth is redistributed dependent upon the type of assets a household holds.

Inflation really acts like a tax--taking real income and wealth from some and giving it to others.  Typically these redistributions are "wrong way" redistributions in that they take from lower income households and transfer to richer households.  That's the opposite of what most think is desirable.

Macro effects of inflation

One of the chief macro effects of inflation is enormous uncertainty.  Consumers and businesses are
uncertain about how to plan.  Some consumers will delay purchases anticipating that prices will
eventually fall.  Others will buy more fearing that inflation will get worse.  Business don't know
what consumers will do in the aggregate.  


This means that there is an effect on output, but it isn't clear what kind of effect.  If, in the
aggregate, people delay purchases then output will fall.  If inflation accelerates purchases,
output rises--but only for a while.

Other effects may include social tension and perhaps some despair.  Hyperinflation is likely to
produce these kinds of effects.

Anticipated vs. unanticipated inflation

If everyone fully and accurately anticipated inflation, it might not do much harm.  Wages and prices
would reflect anticipated inflation, and real output could continue to rise.  Unexpected inflation is
much more problematical.  When it's unexpected, debtors gain and creditors lose.  If you borrow
money and inflation occurs, you repay it with dollars that are worth less.  That harms the lenders.

Almost no one, in fact, has enough information to correctly anticipate inflation.  It is further
complicated by the difficulty of knowing which prices will increase and at what rate.  Inflation,
put simply, causes all kinds of distortions.

Measuring inflation

Consumer price index (CPI)

The most common, but not only, measure of inflation is the consumer price index (CPI).  The CPI is
constructed monthly by the Bureau of Labor Statistics (BLS).  It is based on a market basket of about
400 different goods and services. The market basket is based upon periodic surveys of consumer
expenditure, the most recent being 1993-95.  The BLS sends teams to more than 50 urban centers
in the United States to record the prices of these 400 items.  It is calculated by valuing the basket
at the current month's prices and expressing that value as a percentage of the same basket in the
base period.  The base period is currently the three year period 1982-1984 and the index is assigned
a value of 100 as the base value.  (Statistically the base index is given a value of one, but the
government always multiplies by 100 apparently thinking that makes it easier to see how the
index changes.)

A simplified calculation of the CPI is given in the table which follows.  It assumes a market basket
of three goods and it assumes prices in the base year (year 1 in the table).  Then it shows what
happens in year 2 when the prices change.  Note that the calculation for year 2 is using the same
quantities as in year 1.  That, as we will see, is a problem.  Here is the table with the calculations:

CPI in year 1 (base year)

Basket item               Price             Total expenditure

20 pizzas                  $ 6.00                  $120.00
15 movies                    5.00                      75.00 
10 haircuts                 10.00                    100.00

TOTAL EXPENDITURE                      $295.00

The $295.00 total is given an index number of 100.

CPI in year 2

Basket item               Price             Total expenditure

20 pizzas                  $ 8.00                  $160.00
15 movies                    4.00                      60.00 
10 haircuts                 10.50                    105.00

TOTAL EXPENDITURE                      $325.00

The price index for year 2 is found by dividing the total
expenditure in year 2 by the total expenditure in year 1
and multiplying by 100:

325  x 100  =  110

The CPI went from 100 to 110 in year 2, so prices in
year 2 were 10 percent higher than in year 1.

Problems with the CPI

Many think that the CPI overstates the rate of inflation.  This is for two reasons.  One is that
the market basket changes.  Even the current market basket will not include some newly developed products or services.  So this brings some error into the published CPI.  A second reason is that the CPI doesn't do a good job of accounting for quality changes.  An ordinary
TV set costs more than it did thirty years ago, but it is a much higher quality product than it was thirty years ago.  The BLS makes some adjustment  for quality changes, but many
experts still think the net result is that the CPI overstates the rate of inflation.  Even though
it isn't a perfect measure, many contracts are indexed to the CPI so it is a very important measure.

Other price indexes

Producer price indexes

There are also producer price indexes which measure inflation at the wholesale level.  There
are actually three of them--crude materials, intermediate goods and finished producer goods. 
Over time, these move in tandem with the CPI but they are more unstable.  Producer price
indexes fluctuate much more from month to month than the CPI, and that's why producer
price indexes to not predict the CPI from month to month--even though the media would
have you think so.

GDP deflator

The CPI is not the index used to convert nominal GDP to real GDP.  That calculation uses a
price index called the GDP deflator.  It includes all items in GDP--consumption, investment and government expenditure.  It does allow the contents of the basket to differ as actual expenditure varies, so it is not entirely a measure of price changes.  It typically
registers a lower rate of inflation than the CPI. 

What is price stability

In 1978 Congress decreed that price stability is inflation of three percent or less.  We
currently have less inflation than that.  This is similar to thinking about what
constitutes full employment.  We probably can't have--and would not want--zero
inflation because that would imply little or no quality improvement.  


This brings you to the end of the first part of macroeconomics.  It becomes more analytical in the second part.


To review last year's first exam, click here: Part One Test