Class 11 - Money

Function of Money

I. Medium of Exchange
II. Store of Value
III. Unit of Account

1. Commodity Money
2. Fiat Money

Change to the syllabus:
Just adding chapter 21 tonight
The final will only cover chapters 15, 16 and 21

Chapter 21 - introduces us to ben bernanke pg 470
FOMC meets tomorrow.
On Wednesday, they issue their report. Policy conclusion as to what they will do to the federal funds rate and the money supply. (One of the essay questions on the final will probably be on monetary policy.)

Before we cover the mechanics of central banking, we need to cover the theory of money.
In order for something to be "good" money, it needs to do 3 things:
medium of exchange
store of value
unit of account

Best seminar on the nature of money - 4 months in Russia in mid 1990s

medium of exchange - ppl commonly use it to buy goods and services
store of value - you can hold on to it for months and spend it later. makes saving possible.
unit of account - it's what prices are expressed in

Up until the 20th century, money was mostly commodity money - something with intrinsic value. Metal, stone, tobacco and even salt. "worth his salt" "salting it away". However, salt can literally dissolve. So gold and silver are better. But they tend to be relatively random in when they appear. Hard to run a stable economy based on them because the money supply can vary.

Fiat - declaration - money. Can be increased without limit. This is an advantage, but it can be misused. But if the govt just prints more money, it increases inflation. When there's inflation, the money isn't a store of value. Ppl use other things. Ppl also start using some other currency as the unit of account.

Basis for fiat money - currency and demand deposits. See the book.

The Structure of the Federal Reserve System

Set up in 1913 in response to financial crises
Modified as a result of the Great Depression

Board of Governors - 7 members appointed by the president and confirmed by the senate. 14 year terms. Independent of political considerations. may be reappointed. staggered terms - only one expires every 2 years. president sometimes appoints more when govs retire or die. chairman is appointed by the president (and confirmed by the senate) for a 4 year term. it must be someone who also has a 14 year term.

12 Federal Reserve Banks - each "district" bank with 9 directors who appoint the president of the banks. banks are concentrated on the east coast due to the population distribution in 1913. 2 banks in Missouri (st. louis and kansas city). The 6,000 member commercial banks elect 6 directors of the federal reserve banks.

Federal Open Market Committee (FOMC) - Board of Governors plus 5 federal reserve bank presidents. 4 presidents are on a rotating system. NY fed president is always on the committee because they are the adminitrators of monetary policy - they actually do the buying and selling.

Functions of the Federal Reserve

I. Routing Functions

1. Bank for banks - where banks go when they don't have enough money to cover depositors' demand. it's a "lender of last resort".
2. Bank for federal government - it's where the money that is paid to the govt goes and where govt funds are paid out of
3. Payments system - maintains a system of electronic money transfer and for processing checks

II. Policy Functions - counter-cyclical activities. while everyone else is holdling on to money, there must be something that provides an elastic currency and stimulates demand. and vice versa. "take the punch bowl away just when the party is getting started." fed can take away money, but they can't expand the money supply by itself. people have to want to borrow on their own. banks need to want to lend on their own. according to keynes, the only institution that can expand spending is the federal government. not even local govts can do it.

1. Money supply
2. Interest rates

What instruments does the Fed have to influence the money supply and interest rates?

Fed's Tools of Monetary Policy (most used to least used)

1. Open market operations - buying and selling of federal govt securities: t-bills (30-360 days), t-notes (2-10 years), t-bonds (10-30 years); adding liquidity into the system means buying securities (typically t-bills); bank reserves go up and the fed funds rate goes down. this is the rate that banks charge each other when lending to each other. when the fed is worried about inflation, they drain liquidity from the system, the fed sells securities. bank reserves go down and the federal funds rate goes up.
2. Discount rate - the interest rate that the fed charges banks when it lends them money. currently 0.5%. the fed doesn't directly control the prime rate, but it's important to consumers. it's what bankers charge their best customers. currently 3.25%. it's usually about 3% above the federal funds rate.
3. Required reserve ratio - the amount of cash in the vault or deposits at the fed that banks are required to keep. to cut the money supply, they raise the reserve ratio. see san francisco fed web site - alice rivlin - speech in october to the sf society of certified financial analysts.

these tools are relatively easy to implement - no legislation is required.

Problems with controlling the money supply: it only happens if ppl go to banks.

One final exam essay question will have to do with this: how, when, why does the fed change the money supply.

The other essay question will be on the GDP formula. components of GDP. bottom of 328. Y=C+I+G+NX. No graphs. No calculator required.

There will be 30 multiple choice questions - 10 from each chapter.

8-9:50 on wednesday the 16th

Class 10 - GDP and CPI

Real and Nominal GDP

See Table 2 on pg 332. "Real" means adjusted for inflation. Nominal is not adjusted.

See example of Babe Ruth making $80k in 1931 and A-Rod making $28m in 2007. You have to adjust for inflation. Still, Babe Ruth's $80k in 1931 is only worth about $1m in today's dollars.

The example in table 2 shows the number of hot dogs and hamburgers fluctuating and some inflation happening at the same time.

To calculate the Real GDP, you have to use a consistent price for the hot dogs and hamburgers and ignore the inflation. Pick an arbitrary base year and use that for the fixed price.

To calculate the GDP Deflator, divide Nominal GDP by Real GDP. This is an index value. For the base year, it'll always be 100.

See Figure 2, page 335 - Real GDP in the US vs. time. 2000 is the base year.

Recession is when real GDP declines for 2 successive quarters. NBER.org is an independent, non-governmental research organization that defines when a recession begins and ends.

There is no pattern of recurrence of recessions, no consistency, no periodicity. This makes macroeconomic forecasting is very difficult.

However, you can predict the results of presidential elections based on these economic data. Only the 2000 election doesn't follow the pattern.

See Table 3 - GDP and the Quality of Life, pg 339.

Consumer Price Index - CPI

Data comes from the BLS - Bureau of Labor Statistics

CPI is set up to measure changes in the cost of living for the average US urban household.

It used to be for the avg urban "worker". Now, since it is used for COLA for social security, it includes retirees also.

They conduct surveys, focus groups, spending logs and estimate the typical budget for an urban household and where they spend their money. They construct a theoretical "basket of goods and services". They "buy" those goods and services every month and calculates how much much they cost.

The basket changes over time, slowly, as technology changes, ex: 8 track tape, cassette tapes, lps, CDs, etc. But in general, the basket is fixed.

See table 1, pg 347. Calculate the CPI as (current year cost/base year cost) x 100.

Inflation rate = [(CPI₂ - CPI₁)/CPI₁] x 100
(They don't use a midpoint formula.)

See figure 2 pg 353. CPI and GDP Deflator go together, but the CPI is more sensitive to oil prices.

European central bank considers 2% inflation to be stable prices.

Class 9 - Macroeconomic Measurements

Final exam is Wednesday, December 16, 2009 at 8pm-9:50pm.
There will be class on Monday night, 12/14. Therefore, there are 3 class periods left.

Tonight: Chapters 15 and 16.
Next week: Chapter 21 - The Monetary System
The following week: Chapter 22 - Money Growth and Inflation

This begins the study of Macroeconomics. More interesting, more exciting, more arguable. More questions and fewer answers and therefore more intellectually exciting. 100 questions and 300 answers.

Tonight, we will cover 2 of the 3 major macroeconomic statistics: GDP and CPI.

US economists are most concerned with GDP these days, but we could be focusing on CPI in the near future.

GDP appears to be increasing at present. It went up in 3rd quarter of 2009 and may continue to increase in the next quarter.

Where do these statistics come from?

GDP come from the US department of commerce. The Bureau of Economic Analysis (http://www.bea.gov/) calculates the GDP. The census bureau also plays a part. BEA also provides foreign trade information. They hire thousands of people to put the GDP statistics together. GDP data comes out quarterly. They collect quarterly data from companies.

CPI and Unemployment Rate come from the Bureau of Labor Statistics (part of the Department of Labor). The data is provided monthly.

Gross Domestic Product (GDP)

Definition: Total money value of the final goods and services produced by the residents of a nation during a specific time period.

It used to be measured in GNP, but now the US conforms to the rest of the world and measures GDP. GNP replaces "residents" with "citizens". Therefore, GDP of countries like Dubai is high, but GNP is relatively low.

Ex: If a Greek woman works for a French company at a US location, that production is calculated into the US GDP, because it's produced on US soil, and Greece's GNP because the person doing the producing is a Greek citizen.

GDP is always expressed in monetary terms because its the thing that all goods and services have in common. Ex: Baseball, hot dogs, apple pie and Chevrolet.

GDP measures the value of final goods.
Ex: Paint may or may not be a final product. If it's used to paint a picture that is never sold, then the paint is the final product. If it's used by an artist to paint a picture which is sold, then the paint is an intermediate good and the picture is the final good.

In a country like the US, most of the GDP is in services - non-tangible.

GDP measures production. Even if they're not sold.

GDP is national. However, the EU now also has a consolidated GDP measurement for all 27 member states.

GDP is almost always measured annually or quarterly on an annual basis.

See table 3 pg 339 - 12 most populous countries.

Real GDP is adjusted for inflation. In international terms, its adjusted for "purchasing power" for different exchange rates.

Table 3 implies that GDP tends to influence quality of life.
FYI box on pg 340 implies that GDP tends to influence whether a country will be successful in the Olympics.

Pres Sakozy of France created a commission on the measurement of economic performance and social progress, chaired by Joseph Stiglitz. See http://www.stiglitz-sen-fitoussi.fr/

There is sometimes a trade-off between leisure and economic production. For example, US workers work more hours per year than the workers do in Germany, so it makes sense that US GDP is larger. However, since German workers get more paid vacation per year, you could make an argument that Germans have a high quality of life.

The Stiglitz commission made several recommendations on how to improve the GDP measurement.

The National Income Equation

Y = C + I + G + NX

Y (national income, GDP) is the sum of 4 components.

C = Consumption, spending of the household sector, ~ 70% of GDP. Does not include new residential structures; that is considered investment. C is always tangible.
1. Non-durable goods
2. Durable goods (has most volatility)
3. Services
Only applies to new goods, not on second sales of houses or other similar goods.

I = Investment. There are the expenditures that businesses make in order to produce more stuff.
1. Capital goods - equipment, machinery
2. Structures - buildings, shopping centers
3. Inventories - this is where GDP counts the stuff that is produced but doesn't get sold. This number is good for short-term forecasting, especially the inventories/GDP ratio. If inventories are rising, then there is likely to be a cutback in production in the future. Inventory and supply chain management are the keys to just-in-time production for Toyota. Inventory management is also a key to the success of Walmart.
Keynes ("animal spirits") said that capital goods and structures are the most volatile parts of GDP because they're not immediately necessary. They're based on expectations, and expectation are unmeasureable and unknowable. Government purchases are the "counterweight".

G = Government purchases
1. Federal - federal government can borrow funds and the central bank can create or free up money and can thus counteract the procyclic nature of the state and local government purchases
2. State - tends to be procyclical, they cut spending when incomes are lower, making the recession worse
3. Local

NX = Net Exports
I.e. Total exports-total imports
Not every country can have positive net exports. At least one country has to have a deficit.

Class 8 - Externalities and Public Goods

Tonight we will cover Chapters 10 and 11 and then have an exam review. Exam is next week, Nov 16 over parts 2 and 3. No class on 11/23.

Red Bull is headquartered just outside Salzberg, Austria.

Externalities

Important topic in both micro and macro economics. Basis for government intervention in a market economy.

There are external effects to market decisions.

Examples of market actions that have positive externalities (public goods, external benefits):
buying a swine flu shot, hiring a string quartet.
Education - we're all better off when others get a basic education. There are fewer external benefits to college education. (That's why economists favor public funding of basic ed, but not college ed.)
Medical research.
Publicly funded health care.
Income redistribution.

Govt intervention encourages these transactions in order for the public to receive the positive externalities.

Market transactions that have negative externalities (public bads, external costs):
Buying a cigarette and smoking it - gives harmful second-hand smoke to others
Listening to loud music - bothers others

These transactions may require govt intervention in order to reduce these negative externalities.

See figure 1, pg 205 - you have the classic supply and demand curves.
Supply is a function of the raw materials and labor - fixed and variable expenses of production. This is the private cost. The public cost includes the cost to the environment due to pollution during the process.

To include the total cost, we add in the public costs, shifting the supply curve upward (a higher total price) so we include the cost to the public for cleaning up the environment.

Total cost is private cost plus external costs. Environmental economists try to estimate the external costs, cleanup, lower life expectancy, poorer crops, etc. But it's very difficult.

This explains why, at some point in the future, we'll pay more for petroleum products. Now, we only pay for the private production costs (plus some taxes), which are low. In the future, we'll be paying for the environmental costs as well. (Although there are some positive externalities to low-cost fuel as well.)

For positive externalities, see figure 3, pg 208.

Example: paying to send kids to private school makes them more behaved. That has private value to the parents and also an external benefit to society.

Since these additional benefits apply to the consumers, we shift the demand curve up. This is what society "should do" so that the quantity demanded/supplied is increased.

See Krugman article - The Textbook Economics of Cap-and-Trade. This is very similar to figure 4 on page 214.

The deadweight loss (red triangle) is the amount that producers will no longer be able to earn money from for those additional emissions.

In this scenario, govt is setting the emissions cap. Permit price is determined by the market.

Copenhagen convention may determine the caps for each nation.
In favor: Sierra Club, Environmental Defense Fund

Distinguishing between public and private goods

See Figure 1 pg 226. Matrix is based on work of Paul Samuelson.

Key characteristics:
1. Rivalry in Consumption - is there competition? if one person has more, do others have less?
2. Excludable - can others be kept out

If both, it's a private good. Market system is the best allocator of private goods, especially if there are few external benefits or external costs.

If neither, it's a public good. No rivalry in comsumption and not excludable. Ex: tornado siren.

Class 7 - Supply, Demand and Government Policies

Test will be Nov 16th, not on Nov 9th as previously announced. Covering chapters 4, 5, 6, 10 and 11.

Wants to cover externalities and public goods
Today Ch 6
Ch 9 will not be covered
Focus on Ch 10-11 next week
Revised schedule will be posted to Blackboard and an email will be sent.

After the test, focus will be on Macroeconomics.

See end of chapter 5 - pg 110-11 - problems and applications dealing with price elasticity of demand, midpoint formula (pg 92).

Alfred Marshall (mentor of Keynes at Cambridge) invented the demand elasticity curve. He wasn't a mathematician so he interchanged the independent and dependent axis on the curve.

1. a. mystery novels. required textbooks are a necessity so they are less elastic. (publishers understand this and therefore raise prices to the levels that we see)
b. beethoven. it's more narrowly defined and therefore there are more substitutes for it.
c. over 5 years. time horizon is broader. (cta is assuming price inelasticity for fares. however, over the long run, it may be elastic and lead to lower revenues.)
d. root beer is more elastic. there are many substitutes.

2. (more calculations than we would see in a test)
this is a question of yield mgmt (see Hemispheres magazine, main article on October issue)
a. use the midpoint formula for elasticity of demand:
for business travelers
[-100/(3900/2)] / [50/225] = -0.051 / 0.222 = 0.23
this is an inelastic demand curve. it's less than 1.
for vacationers
[-200/700] / [50/225] = -0.286/.222 = 1.287
this is an elastic demand curve. it's greater than 1.
b. there are substitutes

6. - never did this problem

12. To answer this question you must first know (or at least have a feeling for or a judgement of) the price elasticity of demand. If it's less than 1, increase the price. If it's more than 1, decrease the price.

13. slope of pharma demand curve is steeper than the computer demand curve. as supply increases and the supply curve shifts to the right, equilibrium price goes down. pharma experiences a greater decrease in price decrease. computers have larger change in quantity demanded. the elastic demand in computers means that the quantity increase is larger than the price decrease and therefore total revenues will increase. conversely, the quantity increase for pharma is smaller than the price decrease because the price elasticity of demand for pharma is less than 1.

Handout: The textbook economics of cap-and-trade by Paul Krugman, Sept 27, 2009
This article is background for understanding the UN-sponsored Copenhagen summit on climate change.

see fig 4b, pg 214
see figure in Krugman's blog
We will go thru this more next week.

Break. After the break, we will zip through Chapter 6.

See chapter 6 - figure 1

Price Ceilings

Non- binding ceiling must be above equilibrium. Such a ceiling is extraneous. It has no effect on the market.

Binding ceiling must be set below equilibrium. In such a case, it will create a shortage. This happens in "real" socialism. Very low prices and lots of shortages. Promise of socialism was that there would be an abundance at low prices. So they set price ceilings, but this caused shortages. Same thing happens with rent control.

Shortages are handled in many ways. Under socialism/communism, it led to long lines and corruption.

See figure 2 - attempts to control prices of gasoline in the 1970s.
initially, the price ceiling was above equilibrium. but then the supply curve shifted and the price ceiling was then below the equilibrium, leading to a shortage.

Rent Controls

see figure 3, pg 117.
An aside: "Friends" was based on rent control. Monica and Rachel's apartment were under rent control. Her grandmother's name was on the lease and the rent control laws said that the rent could not be raised if the leaseholder was still living there.

In the short run, figure A, rent control creates a shortage. In the long run, figure B, elasticity increases on both the supply and dmand side, and the shortage increases.

If there are people who are homeless, some solution needs to be found as an alternative to rent control: public housing (which has many problems) or housing vouchers. Instead of providing housing, provide income subsidies. Same answer for education: vouchers are a better solution than restricting people to a specific school.

Minimum Wage Law

See figure 5. Affect of minimum wage laws. This is controversial and there is a debate as to how much harm these laws do. These laws don't impact educated workers, only young, uneducated laborers. That is the market that the figures refer to. Not the entire US labor market.

Minimum wage laws lead to a labor surplus, i.e. unemployment, in this market segment.

Economists would prefer government subsidies to hire young workers, rather than establishing minimum wage levels.

Taxes on Sellers

see figure 6, pg 125
Supply curve shifts leftward/upward, raising the price to a new equilibrium, but not by the full amount of the tax - because the demand goes down and the sellers end up "eating" the difference.

In the example, the 50 cent tax cost the consumers 30 cents and suppliers 20 cents.

Tax on Buyers

see figure 7 pg 126

A simliar thing happens and the effect of the tax is shared between producers and consumers. It doesnt matter who the initial tax is put upon. It has the same effect.

How much is shared by each side depends on the elasticity of the demand/supply curve.

Class 6 - Elasticity

On the second exam, there will be 2 supply & demand graphs - one from the broad chapter 4 and one from ch 5 elasticity, externalities of private and public goods.

See pg 87 - problems and applications

#3 - 5 different shocks to the system

start with original equilibrium - S1 and D1 curves
use table 1 and/or table 2, then proceed to process described in table 3

a. people decide to have more children - demand change - table 1: number of buyers, shifts the demand curve, to the RIGHT. at p1, we no longer have equilibrium, we have a shortage. this signals to the sellers to raise the prices, to p2.

however, it also signals to the manufacturers to increase the quantity supply, moving us up the supply curve (not moving the curve itself). movement which is only motivated by price is a move along the curve, not a move of the curve.

at the same time, the quantity demand is decreasing due to the increase in price. this continues until the supply and demand meet at equilibirium.

b. a strike by steelworkers raises steel prices - supply-side change - a change of the input prices, shifting the supply curve, to the LEFT. at p1, we again do not have equilibrium, we have a shortage. price goes up. quantity demanded decreases and the quantity supply increases.

e. a stock-market crash lowers people's wealth - a demand-side change - a change of income, shifting the demand curve to the LEFT. at p1, we have a surplus, which leads to a lowering of prices (to p2) by salesmen. this signals to manufacturers to produce fewer - quantity supply drops. it also signals to buys to buy more - quantity demand increases.

4. identify the flaw in the analysis. change in taste, shifts the demand curve to the LEFT. leads to a surplus at P1. excess bread on the shelf. this signals sellers to lower the price. this leads to lower quantity supply and an increase in the quantity demand.

Elasticity

See figure 1 - the price elasticity of demand. pg. 93.

a - perfectly inelastic demand curve - demand is unaffected by price at all. approximates demand for Starbucks coffee.

graph e is the opposite - purchasers are absolutely affected by price. they will pay only one price.

In the real world, demand curves always have negative slopes, like those in graphs b, c or d - most likely like b or d.

Pe = %ΔQuantity / %ΔPrice

elasticity coeffient:
>1 price elastic
<1 price inelastic

What makes demand curves elastic or inelastic?

Determinants of Price Elasticity of Demand: (see pp 90-91)
1. Substitutes
2. Necessity vs. Luxury
3. Definition of the Market - the narrower the market, the more elastic it is
4. Time Horizon - the longer the time horizon, the more elastic it is (Perot proposed a 10 cent excise tax on gasoline each year, allowing people to adjust to it.)
5. % of Total Budget - a smaller percentage make the response to price changes more inelastic

Total revenue test (see figure 2 pg 95).
multiply price x quantity
you need a second p2 and q2 to compare to
multiply p2 x q2

Yield Management - started with hotels, went to airlines, concerts and other industries where there's fixed capacity.

Impact of Drug Interdiction

See figure 9 pg 107
Demand curve is inelastic. It's a necessity for those who use the drugs.

If there's a drug bust, the supply goes down - shift the supply curve to LEFT. Price goes up. This makes the drug lords richer.

If you use drug education to try to decrease the demand and shift the demand curve to the LEFT, that would reduce total revenue.

Supply of Wheat

Farmers want their own output to increase, but not everyone else's.
See figure 7, pg 103.
If the supply increases, total farm income goes down due to inelastic demand (people don't eat that much more just because prices go down).

Class 5 - Market Economies

Outline:
1. Private ownership of resources
2. Consumer and producer sovereignty
3. Role of prices
4. Profit Incentives

Breeze through analytics of supply & demand in ch 4.
Ch 5 is interesting - Elasticity - responsiveness to price changes in the short, med and long run.
Govt intervention (subsidies, rent control, etc)
International trade
Best of ch 10 and 11 - externalities - common resources (see today's Nobel prize winner) - govt ability to handle those common resources

No class on 10/26.

History:
1989 eastern europe - nov 9 berlin wall fell.
1991 in soviet union
rest of 90s they tried to build a market economy.

Economists expected the free markets to easily achieve equilibrium. Similar to financial markets. Markets are more fragile and complicated than people, even economists, think. The softer sciences are very important in the full analysis.

1. Private ownership of resources
Privately-owned resources lead to market economies, even if the government of the country is socialist, such as Sweden. (Volvo, Ikea, H&M, SAS). It's complicated - it requires a recorder of deeds, lawyers, contracts, courts.
US gov't buying shares of GM was not a step away from market economies, it was meant to keep it from falling apart. If the US was heading towards socialism, the govt would be buying good companies, not bad ones.

2. Consumer and producer sovereignty
People have the right to decide and think for themselves what to buy and what to sell. This is one big difference btwn east and west germans in their general attitude. Insurance salesmen were phenomenally successful in east germany because of their attitude. In the former soviet union, entrepeneurs came from hard/pure sciences and literature, because those were the people who recognized the weaknesses of communism and chose those things to study because they are independent. They were the free thinkers.

3. Role of prices
Single most important piece of info in a market economy is the prices. Market prices tell you about demand, availability, scarcity, etc. They provide signals in information to buyers and sellers.

4. Profit incentives
People who understand the information contained in prices, stand to benefit from profits. It has a positive social value.

Market economies take a long time (decades) to develop. They require a lot of infrastructure. You can't just open up free markets and assume they will work.

Market Participants

1. Demand (bring money, leave with something else)
- Buyers
- Purchasers
- Consumers

2. Supply (includes laborers)
- Sellers
- Producers

Supply means how many are available for sale (ex Renoir paintings)

Equilibrium

No moral or ethical connotations. Prior to Adam Smith, there was discussion of what constitutes a "fair" price. See Thomas Aquinas. See page 77, figure 8.

Rising prices are not good or bad. It all depends on whether you're buying or selling.

See figure 10 on page 80. Mankiw provides the sequence of events. Chronology is very important. So is terminology. See tables 1 and 2 on page 71 and 76.

Single most important thing in our textbook (pg 79):
Three steps to analyzing changes in equilibrium
1. Decide whether the event shifts the supply or demand curve (or possibly both)
2. Decide in which direction the curve shifts
3. Use the supply-and-demand diagram to see how the shift changes the equilibrium price and quantity.

See figure 10-11: How shifts in supply/demand affect the equilibrium
See figure 12 - A shift in both supply and demand

See table 4: All 9 possible combinations of supply/demand changes (or non-changes)
Some combinations (where both supply and demand are changing) are ambiguous, but the ambiguity can always be solved if you know the relative size of the increase/decrease in the supply or demand.