Quiz 11 - Questions 4 and 5

When doing Questions 4-5. Please use the following table. The table in the quiz did not transfer through clearly.

Balance of Payments - what you need to know

For the purposes of the final, here is what you need to know about Chapter 34

1) Balance of Payments - A record of all transactions between households, firms and the government of one country and the rest of the world
a) current account - trade balance + net transfers + net interest income
i) trade balance = exports - imports. Exports +, imports -
ii) net tranfers - gifts between countries. Gift to US +, gift to other countries -
iii) net interest income - income you receive from coupon payments (bonds) and dividends (stocks). US recieves (+), US gives (-)

b) Capital account - measures real asset flows (purchases of stocks, bonds, real estate, etc)
Foreign purchase of a US asset (+)
US purchase of a foreign asset (-)

c) reserve account - account that automatically balances out the BOP, measures official reserves
Foreign government purchase of USD (+)
US Fed purchase of foreign (-)

Basically, anything that would increase the demand for US dollars is a plus for the BOP, anything that would require selling of US dollars would be a negative.

II) USD appreciation/depreciation
a) Fed policy - If the Fed raises interest rates, the return on bonds goes up and this makes holding US dollars more attractive, all else equal. The reverse also holds true
b) Demand for US assets (appreciation)
c) demand for US goods (appreciation)
d) demand for foreign assets (depreciation)
e) demand for foreign goods (depreciation)

Quiz 11 - For study purposes

I will paste the answers below

EC 207 – Intro to Macro Economics
Quiz 11 – In class Quiz on Chapters 33 and 34
12/13/2007
Professor Festa

1) _______When nations specialize according to their comparative advantage
a) total production and consumption in the world increases
b) consumption rises in one country but falls in all others
c) Total world production rises but total consumption in the world declines.
d) Poor people suffer

2)_______If there are two goods and two countries, then one country can have
a) a comparative advantage in only one good
b) a comparative advantage in both goods
c) a higher opportunity cost of producing both goods
d) a lower opportunity cost of producing both goods.

3) ______ The ability to produce a good or service at a lower opportunity cost than other producers is
a) absolute advantage
b) the quota system
c) intellectual property
d) comparative advantage.



Product
United States
Mexico
Computers
8
3
Bicycles
2
6




Refer to the above table for 4-5

4) Referring to the above table, what is the cost of producing (opportunity cost) one bicycle in the United States________? What is the opportunity cost of producing one bicycle for Mexico
a. 4 computers, 0.5 computers
b. 0.25 computers, 2 computers
c. 2.67 bicycles, 0.33 computers
d. 0.375 computers, 3 bicycles.


5) ______Referring to question 4, which of the following would be a correct statement
a) The United States has a comparative advantage in bicycles
b) The United States has a comparative advantage in computers
c) Mexico has a comparative advantage in computers
d) Mexico has a comparative advantage in both goods.

6)_______The balance of trade is
a)The difference between exports and imports
b)The value of all goods and services produced
c) A measure of real asset flows
d) The amount of currency central banks hold


7) _________When the value of exports exceeds the value of imports then
a) changes in productivity will occur
b) international trade is in balance
c) the country is running a deficit
d) the country is running a surplus

8) ________ A record of all transactions between households, firms and the government of one country and the rest of the world is the
a) a balance of trade
b) balance of payments
c) international monetary fund
d) government budget

9) _______Which of the following would be considered a positive contribution to the capital account from the US perspective
a) US purchase of a Nokia Cell Phone
b) US purchases of Nokia stock
c) A Swedish purchases of US Dell stock
d) A Swedish purchase of a US Dell computer

10) _______Which of the following would cause an appreciation in the US dollar, all else equal?
a) The federal reserve unexpectedly raises interest rates
b) The federal reserve unexpectedly lowers interest rates
c) US demand for Swiss Clocks surges, causing imports to rise
d) Foreign demand for Dell computers falls, causing exports to fall.


Answers:
A
A
D
A
B
A
D
B
C
A

Class cancelled tonight, but final still set for Tues

I just got a call from the college. Class has been cancelled tonight so we will not be having our final quiz. So I will have to make some amendments.

1) THE FINAL EXAM IS STILL SCHEDULED FOR DEC 18th.
2) QUIZ 11 has been permanently cancelled. Instead I will post the quiz online with the answers and you can use it as a reference for studying
3) I will be posting a review for the revelant chapters between today and Sat. The most important being Chapter 34 on the balance of payments.
4) Due to losing our final review class, I will allow you to turn in one final extra credit project. Here are the terms. It is the same as what currently exists (find an article, write a double spaced one page summary relating it to the class). However, instead of applying it to your quiz average I will apply it to the final. Instead of being worth 2 points I will make it worth 4 points on your final.

If you have any questions, please e-mail me.

Quiz 10 - Due Dec 11

Intro to Macroeconomics - Quiz 10
Professor Matthew Festa
Due in class Tues, Dec 11
Balance of Payments and the exchange rate

1) (5 points) - Tell me whether the following will go in the current, capital or reserve account and whether it is a positive or a negative in its account.
a) A European purchase of a US Dell laptop
b) A US purchase of a Swiss watch
c) A Japanese purchase of Cisco Systems, a US company
d) A US citizen purchase of a Nokia Cell phone, a Swedish company
e) US receipt of interest income from a German bond

2) (5 points) Tell me whether the following would cause an appreciation or depreciation in the US dollar (USD)
a) The new Dell one machine, a US based company, catches fire around the world and is heavily demanded by foreigners.
b) Income among US citizens rises and the demand for foreign produced Cashmere sweaters increases
c) The US housing market is strong and there is good profit to be made by investing in US real estate, even if you don't live in the US
d) Smoogle, the next best Internet search engine, catches on and issues stock. The company is based out of Britain.
e) The federal reserve cuts the Fed funds rate and this causes a general decline in overall rates among US bonds.

Macro Quiz 9 - Due in class Tues Dec 4th

Please use this link for Quiz 9.

Free trade and US sock industry

Greg Mankiw has an interesting post on how the US sock industry has been affected by free trade. Of course, the flip side of this is that socks are being produced more efficiently at a lower cost while jobs/capital has shifted towards areas where we have a comparative advantage,

Class i on Tues

I called the college and classes are our class is scheduled for tomorrow. I will return the tests on that date.

More data - initial claims

Remember in class I told you that the data is coming in all over the place? Well initial claims were just released and came in fairly positive. You can read about it here .

The number of U.S. residents filing for unemployment benefits decreased by 13,000 last week to stand at 317,000, the lowest level in a month, the Labor Department reported Thursday.'

but

The four-week average of new claims rose by 2,000 to 329,750, the highest level since the week of April 21. The four-week average is considered a better gauge of labor market health than the volatile weekly number because it smoothes out one-time events such as weather, strikes or holidays

on the other hand

Economists are puzzled that unemployment claims have remained fairly steady and low even as the nation's job growth has slowed significantly in the past few months.
One explanation could be that firms are not hiring because they're uncertain about the future. That same uncertainty keeps them from laying off workers who might be needed if the economy rebounds

But the job market hasn't slowed to a worrisome extent yet. You can read about the Oct payroll report here. On the other hand, data on the housing is extremely weak and point to continued declines. With the inventories of homes remaining high, there is a very strong case to be made that home prices have a ways to fall and this could hurt consumption, and job growth, in the future.

As you can see, the Fed's job is not as simple as black or white. There is a lot of grey.

Topic 9 (Overview and summation of Chap 10-17)

I) Neoclassical Aggegate supply and demand curve
a) Best represenation is on Page 320 in your book
b) The goal of this graph is to combine the insights of the classical and keynesian viewpoints. So we have a
1) long run aggregate supply curve
2) short run aggregate supply curve
3) aggregate demand curve

II) What should the fiscal and monetary authorities do?
a) Fiscal
1) recessionary gap (make sure you know graph)
i) cut taxes
ii) increase government spending
2) inflationary gap (make sure you know graph)
i) raise taxes
ii) decrease government spending.
3) at equilibrium - have the budget balanced
4) automatic stabilizers - unemployment benefits, progressive tax code

b) monetary policy
1) The Fed has a dual mandate: maintain price stability and full employment. Accomplishing these goals require conflicting policy actions. Here is a rough guide as to what the fed should do.

2) recessionary gap (ditto)
i) open market purchase of government bonds (cut in fed funds rate)
ii) cut discount rate
iii) cut in reserve requirement ratio

3) inflationary gap (ditto)
i) open market sale of government bonds (raise in fed funds rate)
ii) raise discount rate
iii) rase the reserve requirement ratio

III) Critiques of fiscal and monetary policy
1) Fiscal policy
a) Time lag
b) government failure (rational ignorance, biased voters)
c) ricardian equivalence (i.e. rational expectations)

2) Monetary policy
a) Monetary policy may be unable to affect interest rates (liquidity trap)
b) Long term rates may not respond to policy changes.

IV) Examples of policy action
1) 2001 recession, 2003 Fed policy to counteract possible deflation.
2) 2004-2006 rate hikes by Federal reserve in order to prevent inflation
3) 1980 disinflationary action by Volker

Quiz 7 - Due Tues Nov 6

Quiz 7 - Monetary Economics (15-17)
Professor Matthew Festa
EC207 - Intro to Macroeconomics
Due in Class Nov 6, 2007

1) (2 points) - Identify whether each of the following items is counted in M1 only, M2 only, both M1 and M2, or neither

a) A $1000 balance in a transaction deposit at a bank
b) $50,000 certificate of deposit (CD) at your bank
c) $200,000 certificate of deposit (CD) at your bank
d) $50 traveler's check
e) $500 worth of stock in Google.

2) a)(1 point) The required reserve ratio is 20%. What is the potential money multiplier?
b) (1 point) If the Fed injects $10 million dollars into the banking system, what is the maximum the economy can expand?

3) (2 points) Draw the liquidity preference graph (money demand and money supply). Name the 3 tools of the Federal reserve? Which is the one they use the most?

4) (2 points) The Fed says they plan on cutting 25bps of the tool they use the most. Show the effect on the graph. Tell me whether the equilibrium interest rate and quantity of money will be higher or lower?

5) (2 points) Explain the equation MV=PY. Assuming that Y and V are fixed, what will happen if the Fed continually increases M? Is this a classical or Keynesian argument? Show the effect on an AS/AD graph.

Jobs Report

The single biggest monthly report on the economy is the Non Farm Payrolls report, a measure of how many jobs have been created in the economy during a given month. This report is released the first Friday of every month and is usually market moving (that is, stocks and bonds react to it). You can read the WSJ report on today's figure here

The WSJ reports that NFP rose a healthy 166 thousand gain in employment for Oct, helping to ease concerns that a recession is immanent. More important than the headline figure, which can be distorted because it is always revised, is the 3m average of 117k. 117k average over 3m is a healthy figure given market conditions.

Why is this important? Think of jobs as a way to estimate whether aggregate demand is going to be strong or weak. If employers were expecting AD to be weak, then they probably would not be hiring employees in order to boost output. Further, an increase the amount of jobs boosts income and this should help to support spending. This is extra important at a time when falling home prices threaten to hurt consumer spending.

However, economists debate whether this report can be used to predict the economies future. Some economic data is considered to be a "leading indicator of the economy" while others tend to be a "lagging indicator." Click here for a detailed breakdown over which economic data is considered leading or lagging.

In general, the unemployment rate is considered to be a lagging indicator (that is, the economy will slow and then the unemployment rate will rise). The payroll report is sometimes considered a lagging indicator but other times is considered a "coincident" indicator (it falls as the economy is weakening). In this case the markets are likely to consider it a coincident indicator and this should help ease concerns over a recession.

However, all is not well since the stock market fell yesterday and data on the housing market has been extremely weak. Although the stock market could see a rally today, I doubt it will return to the highs of early Oct before the latest round of worries commenced. It is, however, safe to say the Fed will not be cutting next month with GDP and employment coming in rather strong (pointing to decent AD) and oil prices so high (pointing to possible near term inflation).

Topic 8 (Chapter 17)

I) Demand for Money
a) Money balances - people have a desire to hold money
i) transactions demand - for purchases
ii) precautionary demand - for unexpected expenses (like if your car's transmission dies)
iii) asset demand - holding money compared to holding stocks and bonds

b) asset demand - why hold money rather than assets
1) advantages - liquidity and no risk
2) disadvantages - you don't earn any interest or gains in asset prices

c) Demand for money, therefore, should be inversely related to asset prices. For simplicity, we will assume the only asset price is the nominal interest rate. The higher the interest rate, the lower the demand for money (asset demand for money).

II) Tools of Monetary Policy
a) Liquidity preference graph - top of page 426 (the book doesn't mention its name)
b) Money demand (described above) and Money supply (fixed by the fed
c) Tools of the central bank
1) Fed Funds rate - the most used. It is the rate banks charge eachother to borrow reserves. Sale of bonds by Fed (more money supply, lower interest rate). Fed buy's bonds (takes money out, money supply contracts, interest rates rise).
2) Discount rate - the rate the Fed charges to borrow reserves.
3) reserve requirement.

III) Effect of monetary policy on output - use aggregate demand and supply

IV) Monetary policy transmission mechanism
a) Page 435
b) The argument is that lower interest stimulate the economy through higher investment. But it also stimulates the economy through higher consumption
c) However, this is only a short run argument. In the long run expansionary monetary policy can only result in higher inflation.

V) Putting together fiscal and monetary policy with a realistic AD/AS curve
a) aggregate demand - still the same
b) long run aggregate supply - still the same
c) short run aggregate supply - upward sloping now (this is a partial concession to Keyne's. An upward sloping curve means prices rise, but in the short term the market does not fully adjust to the fiscal or monetary expansion.

VI) MV=PY and its relation to the long run
a) definitions
1) M = Money
2) V = Velocity
3) P = Prices
4) Y = output

The Fed cut

You can read the text of the statement accompaning the 25bps rate cut in the Fed funds rate here. Note how the bank hinted they will not be cutting rates at the next meeting.

"The Committee judges that, after this action, the upside risks to inflation roughly balance the downside risks to growth. The Committee will continue to assess the effects of financial and other developments on economic prospects and will act as needed to foster price stability and sustainable economic growth."

Info on Tues (10/30)

A number of students have called me to inquire about classes Tuesday night. I have called NCC and after talking to about 20 people I got information that there is some activities fair on Tues night that is causing classes to be cancelled during our time period. I was unaware of this (as apparently almost everyone else was), so our next class will be on Thurs. Quizzes will be due on Thursday.

Once you have your charter...

You probably want to join the Federal reserve system as a member bank.

Member Banks

The nation's banks can be divided into three types according to which governmental body charters them and whether or not they are members of the Federal Reserve System. Those chartered by the federal government (through the Office of the Comptroller of the Currency in the Department of the Treasury) are national banks, and by law are members of the System.
Banks chartered by the states are divided into those that are members of the System and those that are not. State-chartered banks are not required to join the System, but they may elect to become members if they meet the standards. As of June 30, 2006, there were a total of 7,480 commercial banks nationwide, of which 2,548 were members of the System. The Federal Deposit Insurance Corporation is responsible for supervising non-member banks.
Member banks must subscribe to stock in their regional Federal Reserve Bank in an amount equal to 3 percent of their capital and surplus. They receive a 6 percent annual dividend on their stock and may vote for Class A and Class B directors of the Reserve Bank. However the stock does not carry with it the control and financial interest that is normal for the common stock of a for-profit organization. It offers no opportunity for capital gain and may not be sold or pledged as collateral for loans. The stock is merely a legal obligation that goes along with membership.

How to start a bank

Click here to learn how to start your own bank.

(Note: this website should help you further understand how the banking system works).

Data and the Fed

The WSJ has a good summary of the latest economic data here. For the rare few without a subscription, here is what the article is saying.

The latest readings on the U.S. economy show continuing signs of weakness: Sales of newly built homes over the summer were weaker than previously estimated, September manufacturing was subdued, business inventories are mounting and the job market is displaying worrying signs of erosion.

How do we read this

1) Declining sales of newly built home suggest that construction of further new homes is unlikely to occur. This hurts GDP directly via a decline in residential investment within the GDP formula (C + I + G + NX). Further, since sales are slowing and inventory levels are high, prices are likely to come down and this can hurt GDP via consumption if people are no longer able to tap home equity to fund consumption

2) Rising business inventories suggest that businesses are not selling as many goods as they had anticipated. This points to a slowdown because they are unlikely to continue producing at current levels until inventories levels are back to where they want them

3) Although the latest NFP report suggests a decent labor market, data on "initial claims" has been rising as of late. Initial claims are initial unemployment claims people make when they lose their job so they can continue collecting unemployment.

How bad does this data look? Well, it certainly does not point to robust growth but the text of the article is not as bad as the first paragraph seems.

1) Sep new home sales rose a bit this month, with inventories declining modestly and pricing rising (editorial: although this is probably an illusion since the data is flawed in that it doesn't include cancelled contracts)

2) Business inventories were previously falling, so it may be the case that businesses are rebuilding their inventories back to the levels they want them at. Granted, this doesn't point to further build ups (which means no boost to GDP), but it "may" not mean a slowdown is in order. The strength in business investment suggests this is a possibility

3) Initial claims, while they are rising, are still not that high historically speaking and may be adversely impacted by the recent auto strikes, which temporarily boosted the claims.

How does the Fed respond to this? As you can see, the Fed has their work cut out for them since you can argue the imperfect data either way. However, it does look the downside risks to growth are real and potentially bad. Therefore, the current data is "bad enough" that another rate cut is likely as a hedge against a potential recession. As you will soon learn, monetary policy operates with a lag (between 6-18 months), before the full force of the rate cut can take place. If the recession risks are real, the Fed is going to want to get the rate cuts in the pipeline now because if they wait too long they will miss the recession (then again, on the other side of the coin, if no recession is coming the Fed can stoke inflation).

Now you know why they appoint these guys to 14 year terms.

Fed meeting next week

This is just a reminder that there is a Fed meeting scheduled for Oct 30-31st (the 31st will be the decision). You can read a schedule of all the meetings, plus the previous statements and minutes, here.

The consensus looks to be another 25bps to 50bps rate cut. The predictions market is pricing in a 25bps rate cut with about a 70% chance, a 50bps cut chance has about a 20% chance.

Remember that the Fed is worried about the recession in the housing market spilling over into other sections, causing an economy wide recession. In order to prevent this, the Fed is ordering the New York desk to purchase US government securities, which will increase the supply of money and push the Fed funds rate down. The fed fund rate, in turn, is supposed to influence other interest rates down and stimulate economic activity in the short run.

First bank of the United States

You can read about our very first federa bank here and here

More info on the Fed

The Federal reserve board has a FAQ website that answers many of the questions posed in class. You can access the website here . Here are some answers:

Who owns the Federal Reserve?

The Federal Reserve System is not "owned" by anyone and is not a private, profit-making institution. Instead, it is an independent entity within the government, having both public purposes and private aspects.
As the nation's central bank, the Federal Reserve derives its authority from the U.S. Congress. It is considered an independent central bank because its decisions do not have to be ratified by the President or anyone else in the executive or legislative branch of government, it does not receive funding appropriated by Congress, and the terms of the members of the Board of Governors span multiple presidential and congressional terms. However, the Federal Reserve is subject to oversight by Congress, which periodically reviews its activities and can alter its responsibilities by statute. Also, the Federal Reserve must work within the framework of the overall objectives of economic and financial policy established by the government. Therefore, the Federal Reserve can be more accurately described as "independent within the government."
The twelve regional Federal Reserve Banks, which were established by Congress as the operating arms of the nation's central banking system, are organized much like private corporations--possibly leading to some confusion about "ownership." For example, the Reserve Banks issue shares of stock to member banks. However, owning Reserve Bank stock is quite different from owning stock in a private company. The Reserve Banks are not operated for profit, and ownership of a certain amount of stock is, by law, a condition of membership in the System. The stock may not be sold, traded, or pledged as security for a loan; dividends are, by law, 6 percent per year.

How is the Federal Reserve funded?

The Federal Reserve's income is derived primarily from the interest on U.S. government securities that it has acquired through open market operations. Other sources of income are the interest on foreign currency investments held by the System; fees received for services provided to depository institutions, such as check clearing, funds transfers, and automated clearinghouse operations; and interest on loans to depository institutions (the rate on which is the so-called discount rate). After paying its expenses, the Federal Reserve turns the rest of its earnings over to the U.S. Treasury.

Topic 7 - Money Creation and Deposit Insurance (Chapter 16)

I) A banks balance sheet
a) Assume only commercial banks exist to make things operate. A commercial bank operates by accepting deposits for checkings, savings, cds, etc and using that money to make loans. The bank makes a profit by charging a higher interest rate for the loans it lends than the interest rate it pays for deposits. So to understand the rest of this you need to get that the bank attracts deposits and makes its money by lending those deposits out.
b) The federal reserve requires the bank to hold part of these deposits at the Fed as reserve, in case people decide to show up to the bank one day and get their deposits back.
c) Required reserves - the amount of money the bank must hold as reserve at the Fed
d) excess reserves - any "extra" money the bank holds as reserve. (Total reserves = reserves - required reserves).
e) Deposits (called transactions deposits in the book, are the banks liabilities).
f) reserves and the loans the bank has are its assets.
g) Balance sheet accounting on page 397

II) Money creation
a) in the above example money was not created. It was merely transferred from one place to another. However, as you can see, fluctuations in the money supply can influence inflation. So how is money created?
b) The only institution that can increase or decrease the amount of money in an economy is the Fed.
c) Open market operations
1) Fed buys a US government security (creates 100,000 of reserves, and hence money). The bank buys the security and deposits the money in the bank's reserve account. Hence money supply goes up because this money never existed before
2) Fed sells a US government security (takes away 100,000 of reserves, and hence money). By selling a security the bank is giving the Fed money in exchange for the security.

III) Money multiplier
a) If the Fed buys a US security and creates $100,000 in money, the bank will turn around and lend that money out to an individual or a business. That person in turn will spend the money, creating more deposits at other banks and on and on. This is the entire purpose of the balance sheets on 401-403. The idea is that there is a ripple effect and we have another "multiplier," this time with money.
b) Money Multiplier = 1/(required reserve ratio)
c) This is the potential multiplier. In real life it may be reduced by the following forces
1) leakages

IV) Tools the federal reserve has to implement monetary policy
a) required reserve ratio
b) discount rate - interest rate the Federal reserve charges for reserves it lends to institutions
c) Fed funds rate* - interest rate banks charge to each other for reserves it lends out.

V) FDIC insurance to prevent bank failures

Topic 6 - Money and Banking (Chapter 15)

Class Notes - Money and Banking (Chapter 15)

I) The functions of money
a) medium of exchange
b) unit of accounting
c) store of value
d) the concept of liquidity (i.e. the ease of converting a house into cash vs having cash on hand).
e) what backs money? - fiduciary monetary system (i.e. trust that the government will maintain stability in money)

II) What is money?
a) monetary base - the bills and coins in your hand
b) m1 = monetary base + transactions deposits (checks and check cards) + traveler's checks
c) m2 = m1 + savings accounts + small denomination time deposits (i.e. cd's less than $100,000 in value) + money market mutual funds
d) the idea is that what we consider money is more than just cash on hand. That is, other assets, like savings account, are close enough to actual money that we should include it in our "broader" definition of money

III) Financial intermediation
a) why do we have banks?
1) asymmetric information - the borrower may have more information about his company than you do, which could lead to fraud if you do not investigate thoroughly. But this is time consuming
2) moral hazard - after the borrower has the money, he may take risks with it that he otherwise wouldn't take. Preventing this is very time consuming
3) big banks can often do things cheaper than people can individually
b) therefore, most people lend and borrow money indirectly via banks rather than lending to each other directly.

IV) Central Banks
a) Purpose
1) perform banking functions for their nations government
2) provide financial services for private banks
3) conduct monetary policy *

V) The US Federal Reserve
a) organization
Board of Governors - 7 full time members. The chair is the head official for both the BOG and the Fed. This is the role Greenspan had for many years. Currently Ben Bernanke is the "Fed chief"
b) 12 Fed district banks (with 25 branches). Each of the 12 district banks has a president.
3) FOMC (Federal open market committee) - BOG (7) + President of the NY Fed + 4 other presidents among the remaining district banks. These 4 voters rotate annually.

VI)

Macroeconomics - Quiz 6

EC207 – Intro The MacroEconomics
Quiz 6
Professor Matthew Festa
The Keynesian Cross Graph and the multiplier
Due on Thurs Oct 25th. I will penalize if late





1) Draw the Keynesian Cross. Note where expenditures and production are on the x and y axis. Then Draw actual expenditure and then planned expenditure curves on the graph. Where is equilibrium and why? ( 3 points)



2) Write the consumption function and explain the components of it ( 2 points)



3) Explain the rationale behind autonomous consumption? How and why would consumption take place at this level? (1 point)



4) If the Marginal Propensity to consumer is 0.8, what is the multiplier? If The government increases spending by $2 million, how much will output increase. If they also cut taxes, how much will output increase? (3 points)




5) Show how this effect will look on the Keynesian Cross Curve. (1 point).

Macroeconomics Quiz 5

Macroeconomics Quiz 5 - Aggregate Supply and demand
Professor Matthew Festa
Due in Class Tuesday Oct 23rd.


1) (2 points) - Draw the long run aggregate supply curve and explain the economic reason why it is shaped the way it is. Use the principles of Say's law in your explanation.

2) (2 points) Draw the "Keynesian" supply curve and explain why it is shaped the way it is. Explain how this differs from Say's law in the first example.

3) (2 points) Explain the three economic reasons why the aggregate demand curve slopes the way it does (draw it to illustrate your point.

4) (2 points) If the government or federal reserve stimulates the economy in such a way that the aggregate demand curve shifts right (i.e. increases), what will happen to the price and output level if we have a classical economy? Why?

5) (2 points) What will happen in a Keynesian economy? Why?

No class tonight

I apologize for the lateness of this notice, but it is impossible to hold class tonight due to the roads. I called the college to see if they were going to cancel class and they said no. I argued with them that it was a bad idea to no avail, so I tried to make it anyway just in case there were some people who were somehow able to make it. However, the road conditions by me were so bad that I wouldn't have even gotten there until after class ended anyway (and I left very early).

Obviously, I was expecting many people not to come. But there may be some people who were able to make it and to them I apologize. I will be speaking to those responsible for allowing the school to remain open in these conditions tomorrow.

Topic 5 - Aggregate Supply/Demand and fiscal policy

Parts of Chapters 10-12

I) Output in the long run
a) long run aggregate supply curve
b) why it is vertical - read this
c) shifts in the long run supply curve

II) Aggregate Demand Curve
a) The total of all planned expenditures in the economy
b) why it is downward sloping
i) real money balance effect
ii) interest rate effect
iii) exchange rate effect - note: for more on these three, read here.

(This takes us to page 246 in the book). Now we will go to Chapter 11

III) Classicals vs Keynesians
a) Say's law and the vertical long run supply curve - read here
b) Why do the classicals believe this?
c) Keyes and the horizontal supply curve
d) Keynes arguments against the classicals

(This ends at page 270 in Chapter 11)


(Chapter 12)

IV) The Keynesian Cross.
a) Read here for more . I personally believe the books explanation is long winded. You may agree or disagree with me. However, I do recommend taking a look at the web page I provided as an alternative way of understanding this graph
b) The keynesian cross works if we assume that the price level is fixed (the supply curve is horizontal).
c) consumption function y = c0 + mpc(y-t)
co = autonomous consumption
mpc = marginal propensity to consumer
y = income
t = taxes
d) the multiplier effect (page 305) 1/(1-MPC)
e) The multiplier effect argues that spending more money via either tax cuts or government spending increases spending by more than the actual amount spent. The argument is like dropping a pebble in water and having the ripple effect be bigger than the actual pebble. If you give someone a $100 and he spends it, the money goes to someone else who spends it, and then that person spends it, etc. etc.

Aggregate Supply/Demand Model

The aggregate supply and demand model is the model you need to know cold in macroeconomics. It is the model you will use to judge the effects of fiscal and monetary policy in both the short and long run. Let's talk first about aggregate demand and then aggregate supply

Aggregate demand -

The aggregate demand curve looks a lot like your normal demand curve in that it is downward sloping, the lower the price the more aggregate demand. However, the reasoning for the downward slope is different. There are three reasons for the downward sloping demand curve and I cannot explain them better than this website. (You can ignore the part from IS/LM on down. That is intermediate macroeconomics).

Aggregate supply -

There are two supply curves. The first is the long run aggregate supply curve, which you can read about here. In the long run the supply curve is vertical because the price level cannot effect output in the long run. Output in the long run is solely a function of labor, capital and productivity. Inflation (price increases) do not increase supply in the long run because workers will demand higher wages, decreasing the extra profits businesses can make and removing the incentive to boost output given the economies productive capacity.

Short run - The problem is that in the short run prices and wages may not adjust quickly. In fact, the economist John Maynard Keynes argued that in the short run the supply curve was horizontal (flat) because prices did not change at all.

These two radically differing views on the supply curve are the key division between classical and keynesian economists.

Why do Classicals believe the supply curve is vertical in the long run -

Say's law - a common (partially wrong) interpretation of this law is that supply creates its own demand. A more reasonable statement of the law is that wages and prices are flexible enough to ensure production is always at its potential, never more nor less. How? Well if you supply goods to the market you pay wages and you generate income. This income is then used to purchase the products you produced. What if people do not spend but instead save? Well then the increased savings lowers interest rates and this boosts investment. So savings is a case where you shift production from consumption to investment. What if demand for the product falls? Then they cut prices. What if the wages are still too high? Businesses will cut wages in order to prevent unemployment.

Therefore, the market itself will adjust via prices, wages and interest rates to ensure that there are no recessions.

Keynesian supply curve - the problem for this view was the great depression. During the great depression prices were sticky (did not change), wages did not fall, and low interest rate did not generate more investment. This suggested that the market was not correcting itself, at least not fast enough. Because of this Keynes argued against the classical's by saying "in the long run, we're all dead."

Wage stickiness is the easiest to understand because oftentimes workers, especially in unions, do not want to accept nominal wage reductions.

Price stickiness is often explained using the example of menu costs. Menu's cost money to print and restaurants do not like reprinting menu's every day cause its inefficient. But what is efficient for one business is inefficent for the economy as a whole. Other reasons for price stickiness is imperfect competition, where a cut in prices does not immediately translate into higher sales (thus it is not undertaken). Businesses sometimes wait for someone else to lower their prices before they do, etc. etc.

Interest rates falling was a phenomonen in the Great Depression. When we get the monetary policy, we will see that the belief that lower interest rates did not stimulate investment and consumption was the major reason why Keynes argued against monetary policy as a tool to fight against recession. But the way interest rates could fail to stimulate the economy is via a liquidity trap. You can read about it here. but

liquidity trap occurs when the economy is stagnant, the nominal interest rate is close or equal to zero, and the monetary authority is unable to stimulate the economy with traditional monetary policy tools. In this kind of situation, people do not expect high returns on physical or financial investments, so they keep assets in short-term cash bank accounts or hoards rather than making long-term investments. This makes the recession even more severe

So who is right?

If the classicals are right, using fiscal or monetary policy to stimulate the economy will lead only to higher prices, not to higher output. If Keynes is right then using fiscal and (although he didn't believe this) monetary policy will stimulate the economy but not prices (note to fellow economists: I am assuming a hyper-keynesian case in order to demonstrate the theory).

After much debate, the mainstream view is now that fiscal and monetary policies will do both in the short term (that is, boost growth and prices), but in the long term the economy operates the way the classicals assume it does. So when we put the model together we will graph a vertical aggregate supply curve for the long run and an upward sloping aggregate supply curve for the short run.

Then we can analyze the effect of the policies you hear about in the newspaper and on TV.

Keynesian Cross

The Keynesian cross is going to be the model we use to study how fiscal policy can be used to counter a recession. This website gives a much simpler explanation than the book does, so I advise you check it out.

Also, if you want to see a good graph of the Keynesian cross, click here.

Note on price controls.

This is in the notes but I want to remind you to focus on price controls, both price ceilings and floors.

Remember that a price ceiling is a maximum price that a market is allowed to charge. If set below the equilibrium rate, this will lead to a permanent shortage

A price floor is the lowest price a market can charge. It set above the market price then a permanent surplus will result. Here the government usually buys all the extra goods up and stores it somewhere to rot away.

The easy economic solution is to remove the price control. However, oftentimes this proves to be tough politically (witness price controls in the agriculture industry).

Outline for Chapter 9 - Long run economic growth

I) Economic growth
a) definition - occurs when there are increases in per capita real GDP, measured by the rate of change in per capita real GDP per year.
b) the limitation of economic growth is that it says nothing about the distribution of economic growth, only whether the overall economy is growing.

II) What causes economic growth
a) increases in labor - this is true for real gdp, but not for per capita real GDP, since the extra output is merely be shared among more people
b) savings - the more savings, the more money for investment in new machinery and equipment
c) productivity
i) measured by dividing total real GDP by the number of workers
ii) productivity increases when you can get more real GDP with the same #of workers

III) productivity and technology
a) new technology for workers is the way you get more productivity. New Growth theory tells us how economies develop these new technologies.
i) greater rewards for technology acts as an incentive to innovate
ii) innovation - more broad than simply inventing. Innovating takes a new invention and applies it to the economy (i.e. the innovators in the computer industry. examples Bill Gates and Steve Jobs)

b) This points to the importance of institutions and human capital
i) institutions - private property, effective government.
ii) human capital - a knowledgeable workforce.
iii) patents - government protection that gives an innovator the exclusive right to make, use or sell an invention for a limited period of time (currently, 20 years).

Quiz 4 answers

Click here for the quiz questions .

Answers:

1) B
2) C
3) D
4) B
5) A
6) C
7) C
8) A
9) A
10) D
11) B
12) C
13) D
14) A

Answer to GDP question in Q3

Click here for the problem:

Answer:

Nominal GDP for 1997

100 spears * $1 = $100
200 Horses *$2 = $400

Nominal GDP for 1997 = $500

Nominal GDP for 1998

200 spears * $2 = $400
300 horses * $3 = $900

Nominal GDP for 1998 = $1300

To calculate the change => (1300-500)/500 = 1.6 * 100 = 160%

For Real GDP I asked you to use 1998 prices, so we have to change 1997 to 1998 prices. We can do this by multiplying the output in 1997 by the prices in 1998

100 spears * $2 = $200
200 Horses *$3 = $600

Real GDP for 1997 = $800

Since we asked for 1998 prices, no correction has to be done for 1998. That is, nominal GDP for the base year (the year we are using as the price level) is equal to real GDP

To calculate the change:

(1300-800)/800 = 0.625 *100 = 62.5%

*Note = Some people you used 1997 prices may have gotten a slightly different answer. This is a problem inherent to this method, which is why the government uses a more complicated method. But the principle is the same and that is what we are interested in.

Economists vs Voters

Bryan Caplan, an economist at George Mason, has an excellent article on how Economists view the world vs how your "average" joe views the world. You can read it here.

Although the article is about why voters and politicians choose bad economic policies, I believe that the article can also be used to teach us what makes an economy grow in the first place. The short answer is markets and the rule of law, but this explanation is a great summary of how we economists think.

There are too many variations on anti-market bias to list them all. Probably the most common error of this sort is to equate market payments with transfers, ignoring their incentive properties. (A transfer, in economic jargon, is a no-strings-attached movement of wealth from one person to another.) All that matters, then, is how much you empathize with the transfer’s recipient compared to the transfer’s provider. People tend, for example, to see profits as a gift to the rich. So unless you perversely pity the rich more than the poor, limiting profits seems like common sense.

Yet profits are not a handout but a quid pro quo: If you want to get rich, you have to do something people will pay for. Profits give incentives to reduce production costs, move resources from less-valued to more-valued industries, and dream up new products. This is the central lesson of The Wealth of Nations: The “invisible hand” quietly persuades selfish businessmen to serve the public good. For modern economists, these are truisms, yet teachers of economics keep quoting and requoting this passage. Why? Because Adam Smith’s thesis was counterintuitive to his contemporaries, and it remains counterintuitive today.

A prejudice similar to the one against profit has dogged interest, from ancient Athens to modern Islamabad. Like profit, interest is not a gift but a quid pro quo: The lender earns interest in exchange for delaying his consumption. A government that successfully stamped out interest payments would be no friend to those in need of credit, since that policy would crush lending as well.

Macroeconomics - Topic 3

Click here for Topic 3, which will give you the outline for inflation, unemployment and GDP

Macroeconomics Quiz 3 - Due Tues Oct 2nd

Quiz 3
Professor Matthew Festa
EC207 – Macroeconomics.
Due in class Tuesday Oct 2nd


1) (2 points)The Kingdom of Rohan has an economy made up of only two goods: Horses and spears. In the Third Age 1997 output and prices were

1997
100 spears for $1.00 a spear
200 horses for $2.00 a horse.

In TA1998, the economy increased the output of both in order to prepare for war against the Dark Lord. Output and prices in 1998 were

1998
200 spears for $2.00
300 horses for $3.00

Based on the information given above, calculate the percentage increase in GDP from 1997 and 1998 in BOTH nominal and real terms. (for real GDP, use 1998 prices)

2) (1 point) Calculate the unemployment rate based on the information given below:

The labor force participation ratio 200 million
Unemployed people = 10mn
Please provide your answer in percentage terms

3) (2 points) Please name and explain in full sentences the 3 types of unemployment and what they are.

4) (1 point) The CPI index in 2000 was 100. In 2001 the CPI index was 110. What is the percentage increase in the overall price level from 2000 to 2001?

5) High inflation is damaging to the economy from the perspective of the fixed wage earner and a lender (i.e. someone who lends money) because? (2 points)

6) Using a graph (in English, zero credit for no graph ) please explain the effects of the following on price and quantity. (2 points)

A new technology developed in which mass machines will now produce HDTV’s instead of the man made way in which these sets were made previously. At the same time Cable television announced to all customers that all stations will now have HDTV capability if the user has a compatible television. What is the effect of price and quantity of these 2 bits of information? (Hint: think carefully)

More Home Sales data

As I expected the new home sales data for Aug came in weak, falling 8.3%. New Home sale prices (median) were down 7.5%. This is arguably a better reflection of the types of price declines that will be needed in order to bring the market into balance. The idea is that home builders will not want to hang onto their inventory nearly as long as existing home owners, so they will cut their prices faster.

Better news came from the job front in the form of initial claims data. Initial claims data is a weekly measure of the amount of people who initiate a claim for unemployment insurance. The amount of people initiating such a claim fell to 298k. This suggests that the Aug labor report, which showed a 4k drop in unemployment may have been an aberration.

Now you can see the difficulty in conducting monetary policy.

Home Sales Data

The world of Macroeconomics moves on at a fast pace and there is some interesting data coming out about the housing market. In short, it is getting worse.

The government releases 3 main indicators of home sales: existing home sales (homes already built being sold), new home sales and pending home sales (when the buyer and seller agree and the deal is pending approval.)

Earlier this week we saw the release of existing home sales. You can read the economist James Hamilton's summary here. As you can see, Aug new home sales dropped another 3.8% from Jul. Worse is that there is a 10.7 month inventory, meaning that it will take close to a year to sell all the existing homes on the market. And if that is not bad enough, this data usually includes deals that were in place about a month ago but just closed in Aug. So they don't even include the credit crunch that happened in Aug (just a few weeks before you started). So as you can probably divine, we should expect home prices to start falling.

Luckily for us, also released this week was the Case Schiller Home Price index. Prof. Hamilton explains exactly how this index measures home prices, but as you can see prices are already falling (3.9% lower from one year ago this month). This does not seem like a lot, but when you couple this release with the article I posted last week , I think we can expect further price reductions in homes.

Due up on the plate tomorrow (Thurs) is new home sales for Aug. This is a good release because it will show more of the effect of the Aug credit crunch as well as offer a price estimate of new homes on the market. If the number is weak, look for more pressure on the federal reserve to cut rates.

What are the short run implications of this?

1) Lower home sales mean less construction of homes, this lowers GDP directly in the short run because companies are not starting home building (decline in investment in residential construction).
2) Falling home prices could (and probably will) hurt consumption indirectly because a lot of consumers probably borrowed money against their home to finance spending (mostly on kitchens, living rooms, etc.). This impact is the most debated among economists. Some argue the effect will be huge, some argue the effect will be small.
3) The inability of mortgage borrowers of ARM's to pay off their loans coupled with the markets inability to tell who is going to default and where, means that the market is punishing everyone via higher interest rate spreads. This should hurt consumption and investment.

Medium term implications?

The short run fall in growth is already inducing Fed rates cuts. I would be further rate cuts are in the making and so does the market. If the fed plays this right, they will balance the risks to growth to the risks to inflation. However, if they cut too much then they run the risk of pushing inflation up in the medium term. (Professor Greg Mankiw of Harvard has an interesting post on whether this is being anticipated by the market). If they do not cut enough then the short run effect will be more pronounced, but the market will stabilize.

Long run implications?

As we discussed on Tues, the long run implications are fairly straight forward. Over the long haul the market will adjust. Home prices will fall enough to induce more buyers into the market. Once the inventory of homes is sold, construction of new homes should pick back up and growth will resume (especially as home prices start stabilizing). Growth will return back to normal.

The housing market and macroeconomics

This is a good NY times article on the housing market. Click here .

The jist of it is this paragraph.

“The buyers and the sellers are the same people in this market,” Professor Mayer said. “So if the sellers price so high that they, effectively, put themselves out of the market, it shows up on the buying side, too.”
He notes that economists at the Federal Reserve and elsewhere keep close tabs on this kind of behavior because the purchases of durable goods like furniture, appliances and televisions tend to run hand in hand with home purchases — and durables have a disproportionate influence on the business cycle. Further, because the freezing of the housing market makes it harder for people to move, it reduces the likelihood that they can quickly relocate for higher-paying jobs. Dysfunction in the housing market can spill over into the job market, too."

The idea is that sellers do not want to accept a price loss on their home. So they price their homes too high for demanders to buy (a surplus). Since the housing market is "illiquid," it takes a long time for them to accept the fact they made a bad investment, lower the price and cut their losses.

However, this has "macro" economic implications in the sense that people buy furniture and other durable goods when they move into a new home. So sales of those products suffer (demand shifts left/down). Further, sometimes these people are so irrational that they refuse to sell their home even though it means they have to turn down a higher paying job. So the job market suffers due to a shortage of workers.

Macroeconomics Quiz 2 - Supply and Demand (continued)

EC208 Intro to Macroeconomics – Quiz 2

Professor Matt Festa

Due in class: Tuesday Sep 25th.

1) Draw the supply and demand graph for cement. Developing countries have been growing extremely fast for the past 5 years and the government are now required to improve the roads and infrastructure in the countries. Show any shifts in the supply and/or demand curve for the cement market and tell me the effect on price and quantity. (2 points)

2) Draw the supply and demand graph for bagels. A recent study by weight watchers has shown that one slice of pizza is about 10-12 points on the point scale. Given that the average weight watchers client can only consumer 20-25 points a day, this means that 1 slice of pizza is about half the allotted food a client can eat the entire day. Before this study, consumers assumed that the points were about half the new estimate (around 5). Show any shifts in the supply and/or demand curve for the pizza market and tell me the effect on price and quantity. (2 points)

3) Draw the supply and demand curve for the crude oil market. A recent hurricane hit the southeastern part of the United States. Unfortunately for the oil industry, most of the countries oil refineries are located right along this area. Most of them have been destroyed and now much less oil can be processed for consumption. Show any shifts in the supply and/or demand curve for the crude oil market and tell me the effect on price and quantity. (2 points)

4) Draw the supply and demand for nursing care. Over the past few years the average age of the population increased from 40 to 45 years (meaning there are now more older people in the population. Show any shifts in the supply and/or demand curve for nursing care. What will be the effect on price and quantify of this change in the population composition? (2 points).

5) Draw the supply and demand curve for Ford. Ford develops a new technology that allows for cars to be manufactured quicker and cheaper. In addition, the news reports have been praising the new Fusion car for its fuel efficiency and hot style. Show any shifts in supply and/or demand. What will be the effect on price and quantity of this new information? (2 points).

Reminder

That quiz one is due today. Click on the link on the right hand side of this webpage for the quiz.

Fed meeting today

If you weren't aware there is an important Federal reserve meeting today, where the bank is expected to cut the fed funds rate either 25bps (5.0%) or 50bps (4.75%). "Bps" is a financial term that translates as 1% = 100bps.

You can read our current Fed chairman's views on the Great depression here. It's a bit complicated for someone with no macro, but it will be interesting to see how much you "get" now versus how much you "get" after finishing the course. (Of course, I will explain things in plain english).

Economics graduates are exploding in #'s

Check out the link here

Here is an interesting fact:

Meanwhile, elite schools are reporting that the number of economics majors is exploding. For the 2003–2004 academic year, the number of economics degrees granted by U.S. colleges and universities increased 40 percent from five years previously. Economics is seen by bright undergraduates as the path to a high-paying job on Wall Street or at a major corporation.

Of course, as an economist it is always good to look at the data.


Random Selection

Economics - Starting 74,000 10y average 189,000
Accounting 54,000 115,000
Finance 90,000 250,000
Comp Sci 58,000 108,000

It seems that the argument is correct with respect to Economics and Computer Science. However, I would be interested in seeing the figures for Finance majors. One possible explanation is that the average in Finance is biased by a few outliers (who make a ridiculous amount of money), although one would think the same argument holds for economics majors (which compete for similar positions).

Macroeconomics Quiz 1 - Due Tues Sep 18

Intro to Microeconomics – Quiz 1 – Supply and Demand.

(10 points)

Professor Festa 18/09/2007

This Quiz is due in class by Tues Sep 18th

Please put work on a separate piece of paper.

Use graphs where necessary.

1) Please draw a supply and demand graph with price and quantity on the correct axis. Provide me with the common sense reason plus one additional economic argument as to why the demand curve slopes down with respect to price? (2 points)

2) Why do we normally assume that the supply curve slopes upwards? (1 point)

3) Where will the equilibrium price be on the graph? Explain and show why that is the equilibrium point and not another point on the graph. (2 points).

4) Name 2 characteristics that will shift the demand curve. Then give an example for each and explain which way the demand curve will shift (draw the graph). (2.5 points).

5) Name 2 characteristics that will shift the supply curve. Then give an example for each and explain which way the supply curve will shift (draw the graph). (2.5 points).

Bad employment report

As we get into macroeconomics we will be discussing employment and unemployment. Today saw the release of the Aug Non Farm payroll report ( basically non farm sector job growth). The report was unexpectedly bad and you can read about it here.

The Federal Reserve is widely expected to lower the fed funds rate -- the rate at which banks lend to each other -- for the first time in over four years when it meets on Sept. 18, by 25 basis points to 5%. It has already lowered the discount rate it charges banks that borrow directly from the Fed by 50 basis points.

The key question I want you to ask yourself is why a weak employment report would cause the Federal reserve to "cut" the fed funds rate (currently at 5.25%, expected to be cut to 5.0 or 4.75% on Sep 18th).

Answer (you may not understand this until we cover the relevant section).

The federal reserve has a dual mandate, full employment and price stability. Up until recently the Fed was primarily worried about inflation or price stability. Therefore they had what is called a hawkish bias. That is, they were more inclined to raise rather than lower rates. Higher rates increase borrowing costs and slow the economy and the price level down.

Now with the housing market in a full blown recession, there is worry that this particular market will cause a full blown economy wide recession. The latest employment report signalled that this probability has increased since firms have stopped hiring workers, at least for this month. Therefore, the markets are now expecting the Fed to cut the rate in order to lower borrowing costs and provide an incentive for firms to hire workers and boost the growth rate.

Macroeconomics - fall 2007 outline

Part I - Introduction to Economics

Chapter 1 - The Nature of Economics
Chapter 2 - Scarcity and the world of trade offs
Chapter 3 - Demand and Supply (will work in some concepts from Chapter 4)

Part II - Macroeconomic Basics

A) Basic Macroeconomic variables
Chapter 7 - unemployment, inflation and deflation
Chapter 8 - GDP (probable test 1)

B) Macro Economic Theories
Chapter 10 (and parts from 9) - Economic growth in the long run
Chapter 10-11 - Classical vs Keynesian economics, the multiplier
Chapter 15 - Money and Banking
Chapter 17 - Monetary policy (probable test 2)

C) The global economy
Chapter 33 - Comparative advantage and free trade
Optional - Chapter 34 - Exchange rates and the Balance of Payments

Fall 2007 Syllabus - Macroeconomics

Nassau Community College
Department of Economics and Finance

Course Outline: Economics 207: Principles of Macroeconomics, 2007– 2008

Required Text: “Economics Today – The Macro View” 14th Edition.
Roger LeRoy Miller; Pearson Education 2008.

Optional Texts: Other articles that I will incorporate into the class will either be provided by me or available free online.


Instructor: Matthew Festa, MA E-mail: M.fest19@gmail.com
Telephone: (cell) 516-987-0299 Dept: 516-572-7181
Office: None Office Hours: by request

Part I: What is this course about?

Catalog Description: This is an introductory course which views behavior of the economy as a whole and the problems of economic organization. Students will explore the fluctuations of output and prices. Problems and measurement of economic growth, inflation and unemployment as income will be discussed. Money, credit and financial institutions will be analyzed, as well as their impact on fiscal policies and international trade

Online resource: This semester I will try and incorporate the internet into the class. I found last semester that lots of quizzes, articles and even this very syllabus went missing for mysterious reasons that defy explanation. Therefore, I will try and get around that problem by posting most take home quizzes, class outlines, article, the syllabus and the course outline online on my blog. You can access this material here: http://increasing-returns.blogspot.com/ On the right hand side are the links to all important documents so you do not have to search for them.

II Grades

30% exams (2 tests)
30% Final
30% Quizzes
10% class Participation

I will be giving 2 tests, the dates of which I will determine as the course progresses. Individually each midterm will be worth 15% of your grade. A final, given at the end of the term, will be 30% of your grade. I will be giving a take-home quiz/homework assignment once a week that you can take from the comfort of your home. Each quiz is 10 points. To get your quiz score you simply divide your points by the total possible quiz points. However, since quizzes can be annoying, I will do the following. I will allow each student the option of substituting his or her quiz average for their lowest midterm grade (note: this option is not available for the final exam). As you will soon learn, incentives matter, and this should provide you with enough of an incentive to take these quizzes seriously. It also gives you a bit of a leeway if a bad day occurs on one of the midterms. No Makeup exams will be given unless there is an extraordinary circumstance. If you believe you qualify please contact me immediately.

So what about class Participation? I am basing your class participation grade mainly on your attendance and your participation in class (i.e. questions are good, sleeping is not). I will allow up to 3 absences without penalizing your class participation grade. This should allow you room in the event that you cannot make any one class for whatever reason may arise.

Extra Credit: As a student I always loved extra credit opportunities and I believe they are a good learning tool. So here is how I will help you. If there is any article that you come across that is relevant to the class (either on your own or on the website) I want a 1-2 page analysis of what the article is saying and how it applies to what I have taught you. You can do up to 3 with each one worth 2 points (maximum 6 points).

Math Background: Economics is an empirical science and thus knowledge of mathematics is essential to success in the discipline. However, being that this is a principles class, I am going to restrict the math to the basics: so knowledge of arithmetic is required for this class. Calculators are permitted (as they will be when you get a job). You do not need to know advanced math, but I will ask you to do some arithmetic work on the quizzes and tests.

Withdrawal Policy – Department Policy for withdrawals is as follows: Students can withdraw from a course at any time up to and including the official withdrawal date of November 5th. After that date, students will only be given withdrawal for extraordinary reasons supported by appropriate documentation. This documentation will be copied and retained by me.

The “W” grade is only guaranteed to those students who officially withdraw from class and obtain the faculty member’s signature during the automatic withdrawal period. Most important, a grade of “W” cannot be granted to any student who takes the final examination.

Note: The “W” grade may possibly impact financial aid and Academic Standing

More on health insurance

Jane Galt, a writer at The Economist, has a theory why the market for health insurance does not work that well in the United States.

My suspicion is that the employer health insurance system has prevented the emergence of reliable brands. Almost no one has any control over their health insurance, so there is no incentive for companies to develop a reputation for speedy resolution of problems. You can't ask your friends about their insurance. There's not even good reason for companies to give you good service as a private consumer, since you will leave them as soon as you get a job with benefits, regardless of how well they perform. And if you move across state borders, you'll hit a new regulatory regime, which means you'll be buying an entirely different produce anyway...

So I'm not sure how big a problem adverse selection would be in a normal health insurance market. The problem is, we don't have one; we have a system where a few desperate and unreliable consumers are trying to buy insurance from a few desperate and unreliable companies.

The big question that is currently unresolved is whether a market can be established that would allow consumers and producers to replicate an optimal market outcome for health insurance. The current problem with the US is that health insurance is tied to your employer. Most people under the medicare age limit are insured via their employer (as are there kids). If you do not participate in the employer based health care system, you are at a loss because there is no pooling mechanism to lower the cost of insurance. Add in state and federal regulation and, depending on the state, individual premiums can be very costly (although on average this may not be the case).

So, we either dismantle the entire system and put a government run system in its place (an idea that the original article I posted below dismantles, I believe) or we come up with another way of pooling consumers so that we can have an individual market. I have heard of at least two ways to do this.

a) Have the government provide a health adjusted voucher to consumers to purchase insurance (that is, if you have cancer you get a large voucher. If you are healthy you get either a small or no voucher). Then let the market work its magic

b) Set up a pooling mechanism where customers can purchase insurance. Customers would not purchase insurance directly from the insurance company. Instead, they would purchase the plan via the pool and then the pool would aggregate the customers and negotiate terms with the insurance company.

Of course, the Ideal libertarian/free market solution would be to remove any and all incentives for health insurance and use tax free health savings accounts (perhaps with government matching/funding for the poor) and then let consumers buy their health care directly. However, while interesting I believe that this solution is not politically realistic.

Economist reviews "Sicko"

Austan Goolsbee, the Economics advisor to Barack Obama, reviews Michael Moore's Sicko here.
Here is one snippet.

So, to do as Moore wants in the United States, you would need to do more than just overcome the insurance industry. You would need to cut the salaries of doctors, reform the legal system, enrage our allies by causing their prescription drug costs to escalate, and accustom patients to a central decision-maker authorized to determine what procedures they are and are not allowed to get. Unless every one of these changes comes together, Moore's new system would end up costing an enormous amount of money.

One problem hinted at, but not addressed, in this article is the idea of rationing. As health care costs escalate someone has to pay for this stuff. If its solely the government's responsibility then people will have to accept waiting lines. End of story. The alternative, and much more politically realistic option, is to set a "health care floor" that we do not let people fall below and then allow insurance to provide alternative health care plans at differing prices. You want more coverage and less wait, then pay more for it. There are ways around the asymmetry problems discussed in the article that would allow this type of market to work.

Update: An Economist reviews an Economist's review of Sicko

Economist Arnold Kling objects to a good portion of Austin's review.

Preventive care is like motherhood and apple pie, but we don't have any hard evidence that we can use preventive care to save money. I would argue that some types of preventive care, such as cancer screening, tend to have a very high cost per life saved.

To "reward doctors for doing a good job," you have to know what a good job is and you have to be able to measure it from far away. This is extremely difficult. Imagine trying to run a system in Washington to pay professors for "doing a good job."

Forced-pooling health insurance is not a solution, because "dump and deny" is not the main problem. A bigger problem with the individual health insurance market is that there are 50 state regulatory fiefdoms, and insurance companies are not allowed to market products across state lines. The biggest problem is that most people think that employer-provided health insurance is "free." So when they do not get insurance from an employer, they cannot bring themselves to pay for what other people get for "free."

Facebook vs Myspace

Apparently Facebook users are more educated that Myspace users. The answer lies in how the two systems evolved with their customer base.

Good application of supply and demand

Professor Greg Mankiw applies basic supply and demand theory to a NY Times article. Click Here

NY Times and interest rates

If you read the NY Times Business section last friday, you would have thought the sky was falling. Click here for the article.

"Homeowners are not the only ones who will have to swallow higher costs. Corporations, accustomed to financing operations with cheap debt, will see their expenses rise, cutting into profits. In addition, rate increases will crimp the private equity buyout boom, which has been fed in large part by the heavy issuance of corporate debt at low rates"

But the Times should have focused more on this sentence:

Stocks have so far shrugged off the jump in interest rates. The Dow Jones industrial average closed at 13,553.72 yesterday, up 71.37 points; the average is 0.8 percent below its high of June 4.

Sure, the negative interpretation of rising interest rates has some bite. All else equal, rising interest rates should dampen housing demand, constrain business activity and dampen growth.

However, there is a positive spin to this that should at least be mentioned. A positive interpretation would mention that after a weak Q1 growth rate of 0.6% annualized, the markets are now expecting Q2 growth to accelerate at a 3.5-4% annualized rate. Increased growth means more borrowing by consumers and business, shifting the demand for capital, and hence interest rates, up.

My theory has just received a thumbs up from Professor James Hamilton over at Econbrowser:

Moreover, if this were purely a rise in real rates induced by either international factors or the Fed, I would have expected to see stock prices fall significantly. If expected future profits and dividends are held constant and the rate at which they are discounted goes up, the stock price would have to fall. Yet we have seen stocks hold their own, even as bond prices plunged, suggesting that rising yields have come at the same time as rising expectations of future profits and dividends.

Let this be a lesson that you should read the business press with a high degree of skepticism. Reading the business section does not constitute an alternative to paying attention and learning the theories.

Income Inequality.

This article has an interesting take on rising income inequality in the Western World, with particular focus on the United States.

A couple of points to elaborate on. The study that removes the effect of young and old workers can be read, in plain English, here.

Some interesting conclusions of the article:

A majority of Americans have no credit card debt. And of the 46 percent of Americans who do, the Federal Reserve's Survey of Consumer Finances says the median balance is $2,100. Moreover, Pew surveys from 2004 through 2006 found that only 9 percent of Americans said that they "owed a lot more [in credit card and installment debt] than they could afford."
Middle class assets are up. Real median net worth for all households rose from $69,000 in 1989 to $93,000 in 2004 -- an increase of 35 percent.
Most household debt is mortgage debt. Mortgage debt as a share of total debt has increased from 71 percent in 1989 to 79 percent in 2004. For the vast majority of people, their major source of wealth is equity in their home.
Bankruptcies are rare. Only 1.5 percent of households declare bankruptcy in any given year.

The data on income inequality is also extremely interesting. On the one hand income inequality is most definitely on the rise.

On the other hand, consumption inequality does not look to be rising as fast. (This can be explained by economics using a lifetime earnings model. Since consumers attempt to maximize total consumption over a lifetime, they will often borrow/save in order to smooth their consumption over a period of years, ignoring periodic up/down swings in income. Since the market has become more efficient in allowing this--think Credit Cards, ATM's, ARM Mortgages---it is reasonable to believe that consumption inequality will be less than income inequality).

On the other hand, the rise in income inequality is an interesting phenomenon worth thinking about. In my opinion, the reason is a combination of technological changes and the superstar phenomenon. In other words, technology has amplified the returns to skills of certain performers.

As to the political implications of rising income inequality I am less certain. On the one hand, the Robber Barron's error could cause a large amount of political strife. On other other hand, do you feel more envious of Bill Gates earning USD50bn or the fact that your neighbor just got a raise to USD100 thousand and is now making more than you?

Of course if there was more equality in the education system then income mobility would likely be higher. But that is not the case right now. It is also the case that we could have a more efficient health care system. But that is a a whole other topic and debate.

What does Economics do to your political leanings

Brad Delong, an economist at Berkeley, has an interesting post on the value of neoclassical (read orthodox) economics here . In one sentence he believes that neoclassical economics is of value to everyone from the center on left since it tempers the lefts radicalism while it is poison to anyone on the right since it radicalizes their views.

Bryan Caplan suggests that the data says otherwise. I would have to agree. Personally, I believe that economics makes you think harder about your political leanings and de-radicalizes your beliefs. For instance, people on the right who have studied economics are more likely to support more immigration than those who do not (with exceptions of course). Meanwhile, leftists who study economics are less likely to support nationalization of key industries and are less likely to see impending doom to driving cars. This does not suggest that either side abandons their beliefs, but their views are more reasoned and easier to accept to the opposing side.

Free Trade Example Sheet

The example I did in class is available online. I strongly recommend using this when doing your quiz .

This is the link

Note: I remind you on the example, but I will do so again. The example starts from scratch. That is, I give you hours work and then we see what each country (in the example person) can produce. Then I calculate the comparative advantage. On the quiz, however, I already give you the production possibilities. Then I ask you to calculate comparative advantage. Thus I have saved you a step and you can just go right towards solving for who has a comparative advantage in what.

Study Outline for Final

The Following Topics will appear on the final

Supply and Demand
Elasticity
Market Failure (not government failure though)
The 4 market models (PC, Monopoly, Monopolistic Competition, Oligopoly)
Free Trade (in the form of the take home quiz and multiple choice.

All the other topics will not be explicitly tested in multiple choice or part 2 problems. However, you should still have some familiarity with production theory in so much as it is used for the market models (so you can't ignore Marginal Cost, but I won't be asking you to calculate it).

Roger Clemens, Supply and Demand.

If you haven't heard, Roger Clemens has signed with the New York Yankees for a pro-rated $28mn dollars (it works out to about $6.5mn a month). Some may be asking, how is such a salary possible. A modified supply and demand graph can provide an easier answer.

Supply - The market for baseball pitchers is extremely small right now. Word on the street says that potential for a trade is extremely thin due to a lack of talent. About the only player left on the market of any quality is (well, was) Roger Clemens. Thus the supply curve for Clemens was completely inelastic, i.e. vertical. Changes in the price level would not effect the supply curve because there was simply no more talent that could be induced into player for a higher salary.

Demand - However, there was strong demand for a good pitcher. 3 teams were vying for another starting pitcher (The Yankees, Red Sox and Astros). The reaons were unrelated to price and more related to making the playoffs and out competing the competition. Therefore, the demand curve shifted right and the salary Roger Clemens could extract from the market shot up through the roof.

Conclusion: When something is in short supply and the demand for it is increasing, price will increase. It's just simple supply and demand.

Economist Bloggers attracting attention

Well, not me.

Quiz 8 - Spring 07

The Link to Quiz 8 -Spring 07 is here. I will post the answers tomorrow, but try the questions again on your own.

Update: The answers to the quiz are

1) D
2) B
3) C
4) D
5) c
6) a
7) C
8)B
9)C
10) B

May 16th

May 16th is the tentative date for the final. Mark your calendar

Diminishing Marginal Returns

This is a review of the law of Diminishing Marginal Returns. Wikipedia says that

"According to this relationship, in a production system with fixed and variable inputs (say factory size and labor), beyond some point, each additional unit of variable input yields less and less additional output."

What does this mean? Notice that the first part of the definition says "fixed and variable inputs." If you have both fixed and variable inputs you know that you are in the short run (in the long run, every input is variable.

Second, the law is saying that beyond some point, adding additional variable inputs yields less and less additional output. In the graph above the MPP (Marginal physical product, which is a fancy way of saying Marginal Product) curve is plotted. Notice that initially the MP curve is going up. Adding additional inputs (workers) yields more additional output. Say adding 1 worker adds 2 extra units of output. Then adding another adds 3 extra units.

However, the law states that beyond some point the MP curve will start to yield less and less additional output. So we go from 3 extra units to 2 if we higher another person and then to 1 if we decide to go even further.

What is happening here is that initially the workers are gaining from specialization, hence MP is increasing. Once that disappears, however, we are cramming more and more people to try and get additional output. Beyond some point, the extra output we get starts becoming less and less until adding another worker would actually start hurting output.

Remember the story of the Hot Dog stand. Initially, hiring additional workers boosted output at an increasing rate because one guy was able to focus on making the hot dogs and the other guy focused on handling the customers. However, as the firm kept adding workers the extra output started diminishing. Think about having 10 workers in one hot dog stand. Hiring the 11th might not do you much good as you already have 10 people there. So you don't get many more hot dogs for the added worker.

Finally, note that in the example above, I had a fixed cost: the hot dog stand. Since this is the short run, I cannot change hot dog stands. If demand is increasing, the only thing I can do in the short run is the higher more workers. In the long run this does not hold as I can always move to a bigger hot dog stand.

Allocative and Productive efficiency in PC

This is related to my previous post on perfect competition.

Remember the definition of both allocative and productive efficiency.

Allocative efficiency is when P = MC. Wikipedia has a definition available here. Productive efficiency is when ATC is minimized. Wikipedia has a definition of productive efficiency here. But I want to explain how we get there in perfect competition. What I want to get across is that Allocative and productive efficiency flows from the very assumptions of Perfect Competition

1) The individual firm cannot influence price because it is a very small player in a very big market. Thus its demand curve is flat. (perfectly elastic)
a) Since its demand curve is flat, it can only have one Price.
b) Since it only has one price, its Marginal Revenue Curve (MR) will also be flat. Further it is the same as its demand curve. Why? Because the demand curve is flat (say price = $5). It will not go lower nor higher than $5 due to the explanation I offered in the previous post. Since it is at $5, each additional unit sold will bring in $5 of marginal revenue. Think about it. If I sell one good rather than 0 I earn $5 instead of 0. Thus my marginal revenue is $5. If I sell 2 instead of 1 I earn $10 instead of $5. So my marginal revenue for 2 goods is 10-5 = 5. Get it?

2) The firm should produce until Marginal Revenue = Marginal Cost. No more or no less (see previous post.)
a) If this is the case, then the firm will produce until Marginal Cost = $5. Why? Because if Marginal Cost is $4 dollars then the firm SHOULD produce more because Marginal Revenue is $5. By producing the good the firm banks an extra $1 in profit. So you see that the firm has to produce until Marginal Cost = $5.

So now we can see why we have allocative efficiency. The very definition of allocative efficiency is that P = MC. In a perfectly competitive environment, the firm produces until MR=MC. Since we have PC, MR = P (look at graph above). Thus, we have achieved allocative efficiency. The market is producing the right goods for the right people at the right price.

3) In perfect Competition, the ATC will be minimized.
Note that this is the definition of productive efficiency (ATC minimized). Why is this the case in perfect competition? Well, if a firm is not producing at the lowest possible unit cost (ATC = $5), another firm will enter the market and undercut them. The firm goes out of business. In other words, competition ensures that every single firm in the industry produces at the least possible ATC per unit. In other words, if Firm A and Firm B are in the same industry--and that industry is perfectly competitive---you only need to find one ATC. If you found one you've found them all. If Firm A's ATC is $5, then Firm B's is $5 as well.

Read on if you want the policy implications of this. (What is below will not be a multiple choice or part 2 problem on the test, but reading it may help illuminate the above).

What I have described above is the best possible outcome for markets. Under the assumptions of perfect competition, we have achieved what is called "pareto efficiency."

That fancy and scary name is really a technical way of saying the following. If a situation exists where I can make one person better off without making anyone else worse off, we a pareto efficient opportunity. Steven Landsburg in his book "The Armchair Economist" gave an example in nature to illustrate this concept. Say you have a flock of birds. The female birds in the flock are attracted to male birds that have "large tails" (you students of Freud are left to make the connection). However, large tails hurt a birds flight as they increase wind resistance. How can we make a pareto efficient outcome out of this. Well, what we can do is take all the male birds and cut their tales off by 2 inches. Therefore, every single bird in the flock has a smaller tale but the ones with the big tales still have a their relatively large tail in comparison with the other birds intact. Every bird can now fly faster and we did not have to disadvantage any of the birds in the process.

This is what perfect competition does with regards to allocative and productive efficiency. The market has created a situation where the most efficient allocation and production of resources has occurred. Nothing can be done to improve efficiency without harming someone at the expense of someone else. Perfect competition has consumers trying to maximize their utility and producers trying to maximize their profits. Market forces ensure that we reach an equilibrium where we maximize the gains to everyone.