Tuesday, October 27, 2009

10 Principles Rap

Hear the 10 Principles of Macroeconomics- Rap Version

Source : Your Textbook Author's Blog

Demand, Supply - Rhythm, Rhyme, Results ( Click for full version including all 10 Principles below)

10 Principles of Economics: Gregory Mankiw, Brief Principles of Macroeconomics 5th edition

1. People Face Tradeoffs. To get one thing, you have to give up something else. Making decisions requires trading off one goal against another.

2. The Cost of Something is What You Give Up to Get It. Decision-makers have to consider both the obvious and implicit costs of their actions.

3. Rational People Think at the Margin. A rational decision-maker takes action if and only if the marginal benefit of the action exceeds the marginal cost.

4. People Respond to Incentives. Behavior changes when costs or benefits change.

5. Trade Can Make Everyone Better Off. Trade allows each person to specialize in the activities he or she does best. By trading with others, people can buy a greater variety of goods or services.

6. Markets Are Usually a Good Way to Organize Economic Activity. Households and firms that interact in market economies act as if they are guided by an "invisible hand" that leads the market to allocate resources efficiently. The opposite of this is economic activity that is organized by a central planner within the government.

7. Governments Can Sometimes Improve Market Outcomes. When a market fails to allocate resources efficiently, the government can change the outcome through public policy. Examples are regulations against monopolies and pollution.

8. A Country's Standard of Living Depends on Its Ability to Produce Goods and Services. Countries whose workers produce a large quantity of goods and services per unit of time enjoy a high standard of living. Similarly, as a nation's productivity grows, so does its average income.

9. Prices Rise When the Government Prints Too Much Money. When a government creates large quantities of the nation's money, the value of the money falls. As a result, prices increase, requiring more of the same money to buy goods and services.

10. Society Faces a Short-Run Tradeoff Between Inflation and Unemployment. Reducing inflation often causes a temporary rise in unemployment. This tradeoff is crucial for understanding the short-run effects of changes in taxes,government spending and monetary policy.

Saturday, October 24, 2009

Campus Sustainability Day and Economic Growth

This past Wednesday was campus sustainability day. In light of that, we can see how the lessons we have learned about technological change economic growth apply to the sustainable use of resources.

One place to see this is on the family farm. We often get the idea from the media that our food industry has been taken over by industrial farms, but the numbers just don't support those notions. Family farms make up 98% of all farms in the U.S. and according to the USDA ERS (2007) non family corporations make up less than 1% of the total number of farms in the U.S. and have accounted for only 6-7% of farm product sales in every census since 1978.

See the following videos to learn more about the technology that is fueling the growth in sustainable agriculture today.

Additional Information:

Structure and Finances of U.S. Farms: Family Farm Report, 2007 USDA ERS

GM crops: global socio-economic
and environmental impacts 1996-
2007 PG Economics (link)

The Environmental Safety and Benefits of Growth Enhancing Pharmaceutical Technologies in Beef Production
By Alex Avery and Dennis Avery, Hudson Institute, Centre for Global Food Issues.

Capper, J. L., Cady, R. A., Bauman, D. E. The environmental impact of dairy production: 1944 compared with 2007. Journal of Animal Science, 2009; 87 (6): 2160 DOI: 10.2527/jas.2009-1781

New York Times Don't Cry Over rBST Milk June 29, 2007

MSN Health and Fitness Bovine Growth Hormone

Dr. Harlan Ritchie, Michigan State University. How safe is our product Beef?

Doyle et al., Institute of Food Technologists, “Antimicrobial Resistance: Implications for the Food System” Comprehensive Reviews in Food Science and Food Safety, Vol.5, Issue 3, 2006

Sandiego Center for Molecular Agriculture Foods from Genetically Modified Crops ( pdf)

Tuesday, October 6, 2009

Income, Poverty and Economic Growth

New York Times: You Are What You Spend-

"Income statistics, however, don’t tell the whole story of Americans’ living standards. Looking at a far more direct measure of American families’ economic status — household consumption — indicates that the gap between rich and poor is far less than most assume, and that the abstract, income-based way in which we measure the so-called poverty rate no longer applies to our society."

Wall Street Journal: Income Mobility- U.S. Treasury Study (link)

"The Treasury study examined a huge sample of 96,700 income tax returns from 1996 and 2005 for Americans over the age of 25. The study tracks what happened to these tax filers over this 10-year period. One of the notable, and reassuring, findings is that nearly 58% of filers who were in the poorest income group in 1996 had moved into a higher income category by 2005. Nearly 25% jumped into the middle or upper-middle income groups, and 5.3% made it all the way to the highest quintile.\"

Income Mobility in the U.S. from 1996 to 2005
Report of the

"Economic growth resulted in rising incomes for most taxpayers over the period from 1996 to 2005. Median incomes of all taxpayers increased by 24 percent after adjusting for inflation. The real incomes of two-thirds of all taxpayers increased over this period. In addition, the median incomes of those initially in the lower income groups increased more than the median incomes of those initially in the higher income groups. The degree of mobility in the overall population and movement out of the bottom quintile in this study are similar to the findings of prior research on income mobility."

From the PEW Economic Mobility Studies:


  Source: The Myth of Middle-Class Stagnation, Steve Conover

From the October 3rd EconTalk podcast, Bruce Meyer discusses income inequality since the 1960's:

"Bruce Meyer of the University of Chicago talks with EconTalk host Russ Roberts about the middle class, poverty, and inequality. Many economists and pundits argue that the middle class has made little or no economic progress over the last 30 years, that poverty rates are stagnant or rising, and that inequality has increased dramatically. Meyer, drawing on his research over the last ten years, argues that these conclusions are either false or misleading. He argues that standard measures of economic progress and inequality are based on faulty inflation data or a misplaced focus on pre-tax income instead of post-tax income or consumption. " 

Some excerpts from Meyer's paper:

Consumption and Income Inequality in the U.S. Since the 1960s*
October 18, 2010
Bruce D. Meyer
University of Chicago and NBER
and James X. Sullivan
University of Notre Dame

"Income data primarily come from the ASEC/ADF Supplement to the Current Population Survey (CPS), which is the source for official measures of poverty and inequality in the U.S. We use data from the 1964-2006 surveys which provide data on income for the previous
calendar year."
What we see is that compare the top 10% (90th percentile)to the bottom 10% the ratio o inequality (income for the top 10% / income for the bottom 10%) has increased very little. Adjusting for taxes, the ratio has went from about 5.5 to about 6.25, while adjusting for taxes and transfers, it has increased from about 4.10 to about 5.75. We don't see drastic changes such as a 10 fold change or even a doubling of the gap as the media might impress. Looking at just the last 10-15 years, the change is even smaller. 
If we look at the top 10% of earners vs. the median earners, (often the most popular claims in the is  that the gap between median income earners and the top earners has gotten larger as median income has stagnated over the last 30 years) we see that the ratio has remained changed very little since 1961, going from around 2.0 to about 2.25 adjusting for taxes and transfers, and has been even flatter since the 90's.
Finally, when compare the median income earners to the bottom 10%, again we find little change in income differences since 1961. There was a growing gap for a period during the 1980's, but those slight increases diminished in the 90's and we finished out 2007 at a ratio right about 2.5 where we started in 1961. 

 As Bruce Meyer's work above indicates, you can't just take income related data at face value. If we look at income inequality based on family market income data used by Picketty and Saez teh picture looks pretty bleak:

Saez, Emmanuel. (2012). Striking it Richer: The Evolution of Top Incomes in the United States. (Updated with 2009 and 2010 estimates). http://elsa.berkeley.edu/~saez/saez-UStopincomes-2010.pdf

 However, there are huge differences in outcomes when we consider how we measure income a well as how we account for things like household economies of scale:

"A Second Opinion on the Economic Health of the American Middle Class and Why it Matters in Gauging the Impact of Government Policy," by Richard V. Burkhauser, Jeff Larrimore and Kosali Simon. National Tax Journal, March 2012.

“Researchers considering levels and trends in the resources available to the middle class traditionally measure the pre-tax cash income of either tax units or households. In this paper, we demonstrate that this choice carries significant implications for assessing income trends. Focusing on tax units rather than households greatly reduces measured growth in middle class income. Furthermore, excluding the effect of taxes and the value of in-kind benefits further reduces observed improvements in the resources of the middle class. Finally, we show how these distinctions change the observed distribution of benefits from the tax exclusion of employer provided health insurance”

 For more details about this methodology, see the April 9,2012 EconTalk podcast with Burkhauser:

CNN Money - CEO Pay

From: http://www.epi.org/publication/webfeatures_snapshots_20060621/ 

When considering income, how might the marginal contribution (in terms of the value of output, consumer surplus etc.)  of a CEO vs. the average worker changed over time? Were there changes in capital (which complements labor)? What about the size of the market served by new products?

You can find a very good discussion of these issues from a Cato Daily Podcast here: Steve Jobs, Profit and Social Obligation

Monday, September 21, 2009

Chapter 6 Practice Problems

#1 If the nominal interest rate is 8 % and the rate of inflation is 3%, the real interest rate is ______%

(Ans = 5%)

#2 A major difference between the CPI and GDP inflator is:

The GDP deflator reflects the prices of all final goods and services produced domestically, whereas the consumer price index reflects the prices of a market basket of goods and services bought by consumers.

#3 Describe 3 problems that make the consumer price index an imperfect measure of the cost of living.

1- substitution bias
2- introduction of new goods
3- unmeasured quality changes

Chapter 5 Practice Problems


#1) Macroeconomists study decisions of economy wide phenomena. (T/F)

#2)The basic tools of supply and demand are central to microeconomic analysis, but seldom used in macroeconomic analysis (T/F)

#3) Many things that society values, such as good health, high-quality education, enjoyable recreation opportunities, and desirable moral attributes of the population, are not measured as part of GDP.

Therefore, GDP is not a useful measure of society's welfare. (T/F)


#4) In a certain economy in 2005, households spent $1,200 on goods and services; purchases of capital equipment, inventories, and structures amounted to $250; government spent $350 on goods and services; and the value of imports exceeded the value of exports by $50. ( or NX =-50) It follows that 2005 GDP for this economy was:

ans: $1750 C =1200 I =250 G = 350 NX =-50
1200+250+350+(-50) =1750

#5) Write the equation that includes the four components of GDP and identify each component.

Y = C + I + G + NX

C= consumption
I= investment
G= government purchases
NX= net exports

Sunday, September 6, 2009

Chapter 3 Practice Problems

1) Explain how absolute advantage and comparative advantage differ.

Absolute advantage reflects a comparison of productivity for one person, firm, or nation. Being more productive gives one an absolute advantage.

Comparative advantage is based on the relative opportunity costs of the person, firm, or nation. Having lower opportunity costs gives one a comparative advantage.

Note: it is possible for one person or country to have an absolute advantage in everything, but it is impossible to have a comparative advantage in all goods and services.

2) Will a nation tend to import or export goods for which it has a comparative advantage? Explain.

A nation will export goods for which it has a comparative advantage. It will do this because it has a smaller opportunity cost of producing those goods.

3) Why do economists oppose policies that restrict trade among nations?

Restrictions on trade prevent countries from receiving gains from trade. Restrictions on trade prevent citizens from achieving greater prosperity. Restrictions on trade are harmful to all countries.

4) Production Possibilities Frontier and Trade

a) Draw a PPF for two goods

b) Show a point indicating a possible efficient level of production and consumption without trade, label it ‘A.’

c) Show a point of possible consumption with trade, label it ‘B.’

d) What does the location of this point in reference to the PPF indicate?

Sunday, May 3, 2009


#1 Describe the role of prices in market economies

Prices serve as signals that guide economic decisions and allocate scarce resources

#2 Even though all markets are not perfectly competitive, the study of perfect competition is worthwhile because:

Some degree of competition is present in most markets, not just in perfectly competitive markets.

#3 Answer the following:

a) a shift from D to D1 is called? A decrease in demand

b)A shift from D1 to D is called? An increase in demand

c) What would cause a shift in the demand curve? Changes in income, prices of related goods, tastes, expectations, the number of buyers - something other than the price of the good in question.

#4 (click to enlarge image)

a)Equilibrium price and quantity are: P = ? Q = ?

ans: 10 , 4

b) At a price of $14, here would be a ? of ? units.

ans: surplus , (6-2 )= 4

c)At a price of $6 there would be a ? of ? units.

ans: shortage , (6-2)=4

Note, in ‘b’ we have an example like with the minimum wage, where we get a surplus of labor and unemployment. In part ‘c’ we have an example of a price ceiling, like price controls that result in a shortage.

#5 Using a graph, demonstrate the difference between a change in ‘demand’ and a change in ‘quantity demanded’.


The movement from A to B along the demand curve is a change in quantity demanded. ( actually an inrease) A behavioral response to a change in the price of the good in question. A shift from D to D2 is a change in ‘demand’, ( actually an increase) a behavioral response to something other than the price of good in question.

#6 Using graphs, illustrate the difference between a change in ‘supply’ and ‘quantity supplied’

The shift from S1 to S2 is a change in ‘supply.’ A behavioral response to something other than price. The movement along the supply curve from point A to point B is a change in ‘quantity’ supplied, which is a behavioral response to price.

#7 What event would be consistent with the following graph ( movement from point A to B)?

a) An increase in gas taxes will reduce dependence on foreign oil
b) Gasoline and diesel are complements, and the price of gas decreased
c) A gas tax was imposed, resulting in higher price paid for gas and a reduction in consumption ( quantity demanded)
d) A gas tax was imposed, resulting in a higher price paid for gas and an increase in consumption ( quantity demanded)

ans: c


1) Production Possibilities Frontier

a) Draw a production possibilities frontier for a society that produces corn and cars.

b) Show an efficient point of production –label it A

c) Show an inefficient point of production – label it B

d) Show an infeasible point of production – label it C

( Click for Larger Image to see the proper graph, and points a,b,c)

e) In a separate graph, show how the frontier changes with improved economic growth.

f) In a separate graph, show how the frontier changes with decreased economic growth.

2) What 3 concepts are illustrated by the production possibilities frontier?

a) efficiency , equity, tradeoffs
b) efficiency, equity, opportunity costs
c) equity, tradeoffs, opportunity costs
d) efficiency, tradeoffs, opportunity costs


3) Circular flow diagram:

a) What does the inner loop represent?

ANS: flow of inputs and outputs

b) What does the outer loop represent?

ANS: flow of dollars

4) In what way do economists take a scientific approach to studying the economy?

they develop theories; they collect and analyze data to evaluate theories

5) Which of the following statements ( there may be more than 1 ) are propositions about which most economists agree? Hint: compare these statements with the ones in your text on page 35 (5th edition)or notes from lecture.

a) A minimum wage helps reduce poverty among young and unskilled workers

b) Effluent taxes and marketable pollution permits represent a better approach to pollution control than imposition of pollution ceilings

c) Corporations should be taxed if profits become excessive

d) The government should pass regulations to limit pollution and protect the environment

e) A minimum wage increases unemployment among young and unskilled workers

ans: b,e


1) What tradeoffs would be involved if society or government requires that firms reduce pollution?

-some firms may have to close
-reduced profits and incomes to the firms owners and employees
-the cost of reducing pollution may fall on some firms more than others, giving some firms a competitive advantage


-reduced pollution may lead to cleaner air and better health
-reduced pollution may reduce effects on the climate
-reduced pollution may improve water quality, biodiversity

2) Prices balance the marginal benefit of consuming a good with the marginal cost of supplying a good. Therefore a person’s willingness to pay for a good represents:

a) availability
b) corporate greed
c) profit
d) the marginal benefit that an extra unit of the good would provide for that person
Ans: D

3) Which statement best describes making rational decisions at the margin:

a) Making decisions that are associated with no marginal cost
b) Making only decisions that can easily be reversed
c) Making decisions only after comparing the marginal benefits and marginal costs
d) Only making decisions if the choices are certain
Ans: C

4) Define: see definitions in the text margins or the glossary in the back of the book

Market failure
Property Rights
Opportunity Cost
Market Economy
Marginal Changes

5) Explain two main causes of market failure and give an example of each.

1)Market Power: ability of a single person or small group to influence market prices. Ex: town with only 1 cable company.

2) Externality: the impact of one persons actions on the well being of a bystander. Ex: pollution

6) What are two method s of correcting an externality that we spoke about in class?

In the case of a negative externality, such as pollution, two methods of correction include pollution taxes, or assigning property rights such as in the form of tradable pollution permits.

Wednesday, April 22, 2009

Earth Week: Environmental Economics Links

'The Invisible Green Hand' Policy Primer from the Mercatus Center at George Mason University

'Why I'm not an Environmentalist' by Economist Steven Landsburg.

Measuring the Economic Effects of Sea Level Rise on Beach Recreation - Link

Green Jobs ( Study that looks at the tradeoffs involvedin 'green jobs' initiatives)

Stern Review ( Climate Change)

Review of the Stern Review
- by Nordhaus

IPCC 4th Assessment Report ( Climate Change) link

The Economics of Local Food

” It is a maxim of every prudent master of a family, never to attempt to make at home what it will cost him more to make than to buy.”

This is tied to the concept of comparative advantage and gains from specialization and trade, which lead to an increase in the size of the ‘economic pie’ which can be used to make everyone better off.

From Marginal Revolution: Food Miles

Research: Environ. Sci. Technol. 2008, 42, 3508–3513 link

Eating Local vs. Organic Tradeoffs- Discussion article link

Eating Local and Climate Change link from National Geographic

Saturday, April 18, 2009

Credit Crisis Visualized Part 1

This 2 part video gives a general description of the financial arrangements that were involved in the current 'credit crisis'. Note the terms 'collatoralized debt obligations' (CDO) and 'credit default swaps' (CDS). Also note the role of the federal reserve and 'cheap credit' or low interest rates.

Credit Crisis Visualized Part 2

Wednesday, April 8, 2009

Fiscal Policy and The Great Depression

Fiscal Policy and the Great Depression
Some Observations on the Great Depression
Edward C. Prescott
Research Department
Federal Reserve Bank of Minneapolis
Federal Reserve Bank of Minneapolis Quarterly Review
Winter 1999, vol. 23, no. 1, pp. 25–31
The Great Depression in the United States was largely the result of changes in economic institutions that lowered the normal or steady-state market hours per person over 16. The difference in steady-state hours in 1929 and 1939 is over 20 percent. This is a large number, but differences of this size currently exist across the rich industrial countries. The somewhat depressed Japanese economy of the 1990s could very well be the result of workweek length constraints that were adopted in the early 1990s. These constraints lowered steady-state market hours. The failure of the Japanese people to display concern with the performance of their economy
suggests that this reduction is what the Japanese people wanted. This is in sharp contrast with the United States in the 1930s when the American people wanted to work more.
FDR's policies prolonged Depression by 7 years, UCLA economists calculate (Press Release)

Also from Journal of Political Economy, 2004, vol. 112, no. 4

There are two striking aspects of the recovery from the Great Depression in the United States: the recovery was very weak, and real wages in several sectors rose significantly above trend. These data contrast sharply with neoclassical theory, which predicts a strong recovery with low real wages. We evaluate the contribution to the persistence of the Depression of New Deal cartelization policies designed to limit competition and increase labor bargaining power. We develop a model of the bargaining process between labor and firms that occurred with these policies and embed that model within a multisector dynamic general equilibrium model. We find that New Deal cartelization policies are an important factor in accounting for the failure of the economy to recover back to trend.
The Great Depression in the United States
From A Neoclassical Perspective
Federal Reserve Bank of Minneapolis Quarterly Review
Winter 1999, vol. 23, no. 1, pp. 2–24

Can neoclassical theory account for the Great Depression in the United States— both the downturn in output between 1929 and 1933 and the recovery between 1934 and 1939? Yes and no. Given the large real and monetary shocks to the U.S. economy during 1929–33, neoclassical theory does predict a long, deep downturn. However, theory predicts a much different recovery from this downturn than actually occurred. Given the period’s sharp increases in total factor productivity and the money supply and the elimination of deflation and bank failures, theory predicts an extremely rapid recovery that returns output to trend around 1936. In sharp contrast, real output remained between 25 and 30 percent below trend through the late 1930s.We conclude that a new shock is needed to account for the Depression’s weak recovery. A likely culprit is New Deal policies toward monopoly and the distribution of income.
5 Myths About the Great Depression
(Wall Street Journal)

Evidence on Tax Cuts

Lawrence Lindsey ( 1987) noted that for incomes greater than $200,000 per year, the Regan tax cuts lead to an increase in reported incomes and increased collections. For those earning > $200K per year, we saw the following increases in collections:

1982 – 3%
1983 – 9%
1984 – 23%
In his book ‘The Vision of the Annointed‘, Thomas Sowell points out the following: ( he obtained this info from ‘Budget of US Government: Historical Tables’. U.S. Government Printing Office, 1994.)

YEAR REVENUE in billions
1981 $599
82 $618
83 $601
84 $666
85 $734
86 $769
87 $854
88 $909

Each year, in the face of, and in the wake of large tax cuts, revenues increased as a result of increased economic activity.

What about the cuts in marginal taxes that George W. Bush implemented in 2003? According to a recent Wall Street Journal article, tax payments from the rich explain the very rapid reduction in the budget deficit to 1.9% of GDP in 2006 from 3.5% in 2003. Taxes paid by millionaire households more than doubled to $274 billion in 2006 from $136 billion in 2003. Accordingly "No President has ever plied more money from the rich than George W. Bush did with his 2003 tax cuts." ( see historical tables link )

Also, straight from the historical tables provided by the office of management and budget you will see that from 2004-2007 there was a 25% surge in tax revenues, ( in face of tax cuts) which was the largest 3 yr surge since 1966. ( again I checked the math)


Robert Barrow. Macroeconomics- 5th Edition MIT Press 1997

Lindsey, Lawrence B. 1987. “Individual Taxpayer Response to Taxcuts, 1982-1984.” J. of Public Economics 33 (July) 173-206

Thomas Sowell. ‘The Vision of the Anointed.’ (1995)

The Wall Street Journal ‘Their Fair Share.’ July 21,2008

Friday, March 13, 2009


These problems sets correspond roughly to chapters in Greg Mankiw's Brief Principles of Macroeconomics 4th Edition, and material will be very similar to the 5th Edition as well. 


Wednesday, March 11, 2009


1 What role do interest rates play according to the liquidity preference theory?

A)when the interest rate increases, the opportunity cost of money increases, so people hold less money
B) Equilibrium in the money market is achieved by adjustments in the interest rate

2 What determines the money supply according to liquidity preference theory? What happens if there is an increase in the money supply? What happens if there is a decrease in the money supply?

The federal reserve determines the money supply .

If the Federal Reserve increases the money supply the money supply curve will shift right and interest rates will decrease. The Aggregate Demand curve will also shift right. If the Federal Reserve decreases the money supply, the money supply curve will shift left and interest rates will increase. The Aggregate Demand curve will shift left.

3. What effect does an increase in government spending have on the aggregate demand curve?

An increase in government spending initially shifts the aggregate demand curve to the right.

4. Explain the multiplier effect. Give an example:

With the multiplier effect, additional shifts in aggregate demand result when expansionary fiscal policy (government spending or tax refund checks) increases income and thereby increases consumer spending. Graphically there is an initial shift from the initial government spending, then an additional shift from the increases in consumer spending.

Example: The government spends money on roads and schools. The owners of the construction companies pay their workers and more teachers are hired to teach. The workers and teachers increase their spending. The firms that the workers and teachers buy goods from increase their production. Spending and income continues to increase, much more than the initial money spent by the government.

5. How does the crowding out effect impact the an increase in government spending?

According to the crowding out effect, an increase in government spending increases the interest rate and decreases investment spending. Graphically the aggregate demand curve may initially shift outward, but then may shift back in. As a result, the impact of government spending on ‘stimulating’ economic activity is less.

Note: The net effect of fiscal policy is uncertain. The multiplier effect increases the effects of an increase in government expenditures while the crowding out effect diminishes the effect of government expenditures. Both effects work against each other.

6. How might a tax cut affect the short run aggregate supply curve?

If the government cuts the tax rate, workers keep more of each dollar they earn, so they work more The quantity of goods and services supplied will be greater at each price level. As a result the short run aggregate supply curve shifts to the right and output increases.

Further, the cut in tax rates will stimulate enough additional production and income that tax revenue actually increases.

7. What is stabilization policy?

Stabilization policy is an attempt by policymakers and the federal reserve to control aggregate demand and stabilize the economy.

Ex: if there is a decrease in aggregate demand due to consumer and investor pessimism, the aggregate demand curve may shift left. A recession may result.
To combat this, the federal reserve may increase the money supply, or the government may increase spending in order to ‘shift ‘ the aggregate demand curve back out . The purpose would be to promote economic recovery from the recession or prevent it.

8. Why are many economists critical of stabilization policy?

A. There is a lag between the time policy is passed and the time policy has an impact on the economy.

B. The impact of the policy may last longer than the problem it was designed to offset

C. Policy can be a source of, instead of a cure for, economic fluctuations

Ex: During the Great Depression stabilization policies may have increased its severity and prolonged the time it normally would have taken to recover.


1 A recession can be described as:

A short period of falling incomes and rising unemployment

2 What role does investment (I) play in economic fluctuations?

It is only a small part of real GDP, but it actually accounts for a large share of the fluctuation in real GDP ( in fact ~ 2/3 of the decline in GDP during recessions)

3 If an economic contraction is caused by a downward shift ( or decrease) in aggregate demand, how would the economy respond on its own i.e. how would the contraction ‘resolve itself’ without government intervention?

(see 4 steps from notes Ch 15, slides, or class discussion/review)

Summary: With the reduction in AD, over time, there is a fall in the expected price level and costs decline. This leads firms to expand output, shifting the short run aggregate supply curve to the right.
The situation is resolved with a lower price level as output returns to its natural rate.

4 What happens when the short run aggregate supply curve shifts to the left?
(see slides ch15 notes, or graph in class discussion /review)

Summary: A decrease in the short run aggregate supply curve leads to decreased output and higher prices. This situation where there is increasing prices and decreasing output is referred to as ‘Stagflation’.


1) Write the equation for the market for loanable funds in an open economy:

S = I + NCO

2) In an open economy, the supply of loanable funds is determined by :

National saving, the same as in a closed economy

3) In an open economy, the demand for loanable funds is determined by: .

the sum of net capital outflow and domestic investment.



1) Write the equation for GDP for: a) a closed economy, b) an open economy

a) Y= C + I + G
b) Y = C + I + G +NX

2) What is the meaning and significance of the equation that NCO = NX?

Net capital outflow = net exports

If a country exports (sells) more goods than it imports (buys), it has a trade surplus, NX is positive. This means that Net Capital Outflow is positive.

If a country imports (buys) more goods than it exports (buys) it has a trade deficit, NX is negative, and NCO is also negative.

What Casued the Financial Crisis?

Did the Federal Reserve Cause the Housing Bubble and the Subsequent Financial Crisis?

Some economists think that the Fed played a role:

( Recall the application of the supply and demand for loanable funds from Chapter 8 relates to this point of view)

See here ( Wall Street Journal) here ( WSJ)
and here ( Ludwig von Mises Institute)

Alan Greenspan, Former Federal Reserve Chairman doesn't think so:

see here ( Wall Street Journal)

For a visual explanation see the following video:

Part 1

Part 2

Austrian Business Cylces Using Supply and Demand for Loanable Funds

Austrian Business Cycles and the Market for Loanable Funds

•Figure 1(b) shows the effect of an increase in credit creation brought about by a monetary expansion from the Federal Reserve. This results in a shift in the supply curve from S to S+ MS’.

•This increase is not based on real households savings; only the injection of new money created by the Federal Reserve.

•As the market-clearing rate of interest falls from I’ to i, businesses increase investment by the amount AB, while genuine saving actually falls by the amount AC.

•Inflating the supply of loanable funds with new money keeps the interest rate artificially low. This drives a wedge between saving and investment.

•This has stimulated temporary vs. sustainable growth, or an artificial boom. The result is unsustainable. A bust follows, and investment falls back into line with saving (not shown in figure 1(b).

Adapted from : David Glasner, ed., Business Cycles and Depressions
New York: Garland Publishing Co., 1997, pp. 23-27

Taxes, Spending, and Unemployment

Government interventions such as unemployment insurance may explain the chronic unemployment issues in Europe. Below are some additional resources that look at employment levels as they relate to government policies in European countries.

Economic Inquiry, 2008, vol. 46, issue 2, pages 197-207

Abstract: "We develop and calibrate a theoretical model that explains per capita hours worked and output growth as a function of three fiscal policy variables. differences in income taxes, productive government expenditures, and nonemployment transfers are sufficient to answer the question why Europeans work (much) less than Americans and why some Europeans work less than others. Differences in taste for leisure have little role to play given the actual variation of these three policy variables." ("JEL" E24, E62, J22, O41) Copyright (c) 2007 Western Economic Association International.


Why Do Americans Work So Much More Than Europeans?
Federal Reserve Bank of Minneapolis Quarterly Review
Vol. 28, No. 1, July 2004, pp. 2–13

Americans now work 50 percent more than do the Germans, French, and Italians. This was not the case in the early 1970s, when the Western Europeans worked more than Americans. This article examines the role of taxes in accounting for the differences in labor supply across time and across countries; in particular, the effective marginal tax rate on labor income. The population of countries considered is the G-7 countries, which are major advanced industrial countries. The surprising finding is that this marginal tax rate accounts for the predominance of differences at points in time and the large change in relative labor supply over time.


Some Observations on the Great Depression


The Great Depression in the United States was largely the result of changes in economic institutions that lowered the normal or steady-state market hours per person over 16. The difference in steady-state hours in 1929 and 1939 is over 20 percent. This is a large number, but differences of this size currently exist across the rich industrial countries. The somewhat depressed Japanese economy of the 1990s could very well be the result of workweek length constraints that were adopted in the early 1990s. These constraints lowered steady-state market hours.


The Marxian view is that capitalistic economies are
inherently unstable and that excessive accumulation of
capital will lead to increasingly severe economic crises.
Growth theory, which has proved to be empirically successful,
says this is not true. The capitalistic economy is
stable, and absent some change in technology or the rules
of the economic game, the economy converges to a constant
growth path with the standard of living doubling
every 40 years. In the 1930s, there was an important
change in the rules of the economic game. This change
lowered the steady-state market hours. The Keynesians had
it all wrong. In the Great Depression, employment was not
low because investment was low. Employment and investment
were low because labor market institutions and
industrial policies changed in a way that lowered normal