Measuring the Economy 1

Introduction and Summary

Macroeconomists use a variety of different observational means in their effort to
study and explain how the economy as a whole functions and changes over time.
One such method relies on personal experience. It is relatively simple to notice
that your company is producing more than it has in the past or that a paycheck
does not go as far as it used to. Yet while personal observations do provide
information about the economy, that information can often be localized rather
than universal, and may not accurately reflect the state of the economy as a
whole.

In order to move beyond the limitations inherent in personal experiences,

macroeconomists begin by systematically measuring the basic elements of the
economy in order to derive standard and comprehensive statistics. This data
provides information about the entire economy rather than simply about a single
household or firm. Two of the most fundamental elements macroeconomists
study are the total output of an economy (GDP) and the cost of living within an
economy (CPI). Gross domestic product, or GDP, is an indicator of economic
performance that measures the market value of goods and services produced
within a country. This measurement is of great importance to consumers since it
also equals the total income within an economy. The consumer price index, or
CPI, is a cost of living indicator; it measures the total cost of goods and services
purchased by a typical consumer within a country. This index allows economists
and consumers to see just how much purchasing power a dollar yields, and to
compare that power between different years and eras. Together, GDP and CPI
show how much income exists within an economy and how much this income
can purchase.

The concepts of GDP and CPI open the door to a scientific understanding of the
functioning of the economy on a large, or macro, level. These are the most basic
tools of measurement used by macroeconomists, policy makers, and consumers
to understand and describe the economy. In fact, GDP and CPI are published
and discussed regularly in the media. Through understanding the concepts of
GDP and CPI, the world of macroeconomics begins to unfold.

Terms and Formulas

Terms
Base year  -  The year from which constant prices or quantities are taken in
calculations of such indices as real GDP and CPI.
Bureau of Labor Statistics  -  The government organization responsible for
regularly gathering data about the economic status of the population.
Consumer price index (CPI)  -  A cost of living index that measures the total
cost of goods and services purchased by a typical consumer within a country.
Fixed basket  -  A set group of goods and services whose quantities do not
change over time. This is used, for instance, in the calculation of the CPI.
Gross domestic product (GDP)  -  The sum of the market values of all final
goods and services produced within a particular country during a period of time.
Gross domestic product deflator (GDP deflator)  -  The ratio of nominal GDP
to real GDP for a given year minus 1. The GDP deflator shows how much of the
change in the GDP from a base year is reliant on changes in the price level.
Gross domestic product per capita (GDP per capita)  -  GDP divided by the
number of people in the population. This measure describes what portion of the
GDP an average individual gets.
Gross national product (GNP)  -  An alternative measure of economic activity to
GDP. GNP is the sum of the market values of all goods and services produced
by the citizens of a country regardless of their physical location.
Nominal gross domestic product (nominal GDP)  -  The sum value of goods
and services produced in a country and valued at current prices.
Real gross domestic product (real GDP)  -  The sum value of goods and
services produced in a country and valued at constant prices, calibrated from
some base year. Real GDP frees year-to-year comparisons of output from the
effects of changes in the price level.
Formulae
 

GDP = [(quantity of A X price of A) + (quantity of B X

price of B) + ... + (quantity of N X price of N)] for
Gross Domestic Product every good and service produced within the country

GDP = (national income) = Y = (C + I + G + NX)

 
GDP growth rate = [(GDP for year N) / (GDP for year
GDP Growth Rate
N-1)] - 1
 
GDP Deflator GDP deflator = [(nominal GDP) / (real GDP)] - 1
 
GDP Per Capita GDP per capita = (GDP) / (population)

Gross Domestic Product (GDP)

The Gross Domestic Product measures the value of economic activity within a
country. Strictly defined, GDP is the sum of the market values, or prices, of all
final goods and services produced in an economy during a period of time. There
are, however, three important distinctions within this seemingly simple definition:

1.GDP is a number that expresses the worth of the output of a country in local
currency.
2.GDP tries to capture all final goods and services as long as they are produced
within the country, thereby assuring that the final monetary value of
everything that is created in a country is represented in the GDP.
3.GDP is calculated for a specific period of time, usually a year or a quarter of a
year.
Taken together, these three aspects of GNP calculation provide a standard basis
for the comparison of GDP across both time and distinct national economies.

Computing GDP

Now that we have an idea of what GDP is, let's go over how to compute it. We
know that in an economy, GDP is the monetary value of all final goods and
services produced. For example, let's say Country B only produces bananas and
backrubs.

Figure %: Goods and Services Produced in Country B

In year 1 they produce 5 bananas that are worth $1 each and 5 backrubs that are
worth $6 each. The GDP for the country in this year equals (quantity of bananas
X price of bananas) + (quantity of backrubs X price of backrubs) or (5 X $1) + (5
X $6) = $35. As more goods and services are produced, the equation lengthens.
In general, GDP = (quantity of A X price of A) + (quantity of B X price of B) +
(quantity of whatever X price of whatever) for every good and service produced
within the country.

In the real world, the market values of many goods and services must be
calculated to determine GDP. While the total output of GDP is important, the
breakdown of this output into the large structures of the economy can often be
just as important. In general, macroeconomists use a standard set of categories
to breakdown an economy into its major constituent parts; in these instances,
GDP is the sum of consumer spending, investment, government purchases, and
net exports, as represented by the equation:
Y = C + I + G + NX
Because in this equation Y captures every segment of the national economy, Y
represents both GDP and the national income. This because when money
changes hands, it is expenditure for one party and income for the other, and Y,
capturing all these values, thus represents the net of the entire economy.

Let's briefly examine each of the components of GDP.

• Consumer spending, C, is the sum of expenditures by households on durable
goods, nondurable goods, and services. Examples include clothing, food,
and health care.
• Investment, I, is the sum of expenditures on capital equipment, inventories, and
structures. Examples include machinery, unsold products, and housing.
• Government spending, G, is the sum of expenditures by all government bodies
on goods and services. Examples include naval ships and salaries to
government employees.
• Net exports, NX, equals the difference between spending on domestic goods
by foreigners and spending on foreign goods by domestic residents. In
other words, net exports describes the difference between exports and
imports.

GDP vs. GNP

GDP is just one way of measuring the total output of an economy. Gross National
Product, or GNP, is another method. GDP, as said earlier, is the sum value of all
goods and services produced within a country. GNP narrows this definition a bit:
it is the sum value of all goods and services produced by permanent residents of
a country regardless of their location. The important distinction between GDP
and GNP rests on differences in counting production by foreigners in a country
and by nationals outside of a country. For the GDP of a particular country,
production by foreigners within that country is counted and production by
nationals outside of that country is not counted. For GNP, production by
foreigners within a particular country is not counted and production by nationals
outside of that country is counted. Thus, while GDP is the value of goods and
services produced within a country, GNP is the value of goods and services
produced by citizens of a country.

For example, in Country B, represented in , bananas are produced by nationals

and backrubs are produced by foreigners. Using figure 1, GDP for Country B in
year 1 is (5 X $1) + (5 X $6) = $35. GNP for country B is (5 X $1) = $5, since the
$30 from backrubs is added to the GNP of the foreigners' country of origin.
The distinction between GDP and GNP is theoretically important, but not often
practically consequential. Since the majority of production within a country is by
nationals within that country, GDP and GNP are usually very close together. In
general, macroeconomists rely on GDP as the measure of a country's total
output.

Growth Rate of GDP

GDP is an excellent index with which to compare the economy at two points in
time. That comparison can then be used formulate the growth rate of total output
within a nation.

In order to calculate the GDP growth rate, subtract 1 from the value received by
dividing the GDP for the first year by the GDP for the second year.

GDP growth rate = [(GDP1)/(GDP2] - 1

For example, using , in year 1 Country B produced 5 bananas worth $1 each and
5 backrubs worth $6 each. In year 2 Country B produced 10 bananas worth $1
each and 7 backrubs worth $6 each. In this case the GDP growth rate from year
1 to year 2 would be:
[(10 X $1) + (7 X $6)] / [(5 X $1) + (5 X $6)] - 1 = 49%

There is an obvious problem with this method of computing growth in total output:
both increases in the price of goods produced and increases in the quantity of
goods produced lead to increases in GDP. From the GDP growth rate it is
therefore difficult to determine if it is the amount of output that is changing or if it
is the price of output undergoing change.

This limitation means that an increase in GDP does not necessarily imply that an
economy is growing. If, for example, Country B produced in one year 5 bananas
each worth $1 and 5 backrubs each worth $6, then the GDP would be $35. If in
the next year the price of bananas jumps to $2 and the quantities produced
remain the same, then the GDP of Country B would be $40. While the market
value of the goods and services produced by Country B increased, the amount of
goods and services produced did not. This problem can make comparison of
GDP from one year to the next difficult as changes in GDP are not necessarily
due to economic growth.

Real GDP vs. Nominal GDP

In order to deal with the ambiguity inherent in the growth rate of GDP,
macroeconomists have created two different types of GDP, nominal GDP and
real GDP.

• Nominal GDP is the sum value of all produced goods and services at current
prices. This is the GDP that is explained in the sections above. Nominal
GDP is more useful than real GDP when comparing sheer output, rather
than the value of output, over time.
• Real GDP is the sum value of all produced goods and services at constant
prices. The prices used in the computation of real GDP are gleaned from a
specified base year. By keeping the prices constant in the computation of
real GDP, it is possible to compare the economic growth from one year to
the next in terms of production of goods and services rather than the
market value of these goods and services. In this way, real GDP frees
year-to-year comparisons of output from the effects of changes in the
price level.

The first step to calculating real GDP is choosing a base year. For example, to
calculate the real GDP for in year 3 using year 1 as the base year, use the GDP
equation with year 3 quantities and year 1 prices. In this case, real GDP is (10 X
$1) + (9 X $6) = $64. For comparison, the nominal GDP in year 3 is (10 X $2) +
(9 X $6) = $74. Because the price of bananas increased from year 1 to year 3,
the nominal GDP increased more than the real GDP over this time period.

GDP Deflator
When comparing GDP between years, nominal GDP and real GDP capture
different elements of the change. Nominal GDP captures both changes in
quantity and changes in prices. Real GDP, on the other hand, captures only
changes in quantity and is insensitive to the price level. Because of this
difference, after computing nominal GDP and real GDP a third useful statistic can
be computed. The GDP deflator is the ratio of nominal GDP to real GDP for a
given year minus 1. In effect, the GDP deflator illustrates how much of the
change in the GDP from a base year is reliant on changes in the price level.

For example, let's calculate, using , the GDP deflator for Country B in year 3,
using year 1 as the base year. In order to find the GDP deflator, we first must
determine both nominal GDP and real GDP in year 3.

Nominal GDP in year 3 = (10 X $2) + (9 X $6) = $74

Real GDP in year 3 (with year 1 as base year) = (10 X $1) + (9 X $6) = $64
The ratio of nominal GDP to real GDP is ( $74 / $64 ) - 1 = 16%.
This means that the price level rose 16% from year 1, the base year, to year 3,
the comparison year.
Rearranging the terms in the equation for the GDP deflator allows for the
calculation of nominal GDP by multiplying real GDP and the GDP deflator. This
equation demonstrates the unique information shown by each of these measures
of output. Real GDP captures changes in quantities. The GDP deflator captures
changes in the price level. Nominal GDP captures both changes in prices and
changes in quantities. By using nominal GDP, real GDP, and the GDP deflator
you can look at a change in GDP and break it down into its component change in
price level and change in quantities produced.
GDP Per Capita
GDP is the single most useful number when describing the size and growth of a
country's economy. An important thing to consider, though, is how GDP is
connected with standard of living. After all, to the citizens of a country, the
economy itself is less important than the standard of living that it provides.

GDP per capita, the GDP divided by the size of the population, gives the amount
of GDP that each individual gets, on average, and thereby provides an excellent
measure of standard of living within an economy. Because GDP is equal to
national income, the value of GDP per capita is therefore the income of a
representative individual. This number is connected directly to standard of living.
In general, the higher GDP per capita in a country, the higher the standard of
living.

GDP per capita is a more useful measure than GDP for determining standard of
living because of differences in population across countries. If a country has a
large GDP and a very large population, each person in the country may have a
low income and thus may live in poor conditions. On the other hand, a country
may have a moderate GDP but a very small population and thus a high individual
income. Using the GDP per capita measure to compare standard of living across
countries avoids the problem of division of GDP among the inhabitants of a
country.

Problems
Problem :

Figure %: Goods and Services Produced in Country C

Calculate the nominal GDP for Country C in year 2.

Solution for Problem 1 >>

Problem : Using , calculate the real GDP for Country C in year 2, using year 1 as
the base year.

Solution for Problem 2 >>

Problem :

Using , calculate the GNP for Country C in year 3 if candy is produced by

foreigners.

Solution for Problem 3 >>

Problem : Using , calculate the GDP deflator for year 2 using year 1 as the base
year.

Solution for Problem 4 >>

Consumer Price Index (CPI)

The consumer price index or CPI is a more direct measure than per capita GDP
of the standard of living in a country. It is based on the overall cost of a fixed
basket of goods and services bought by a typical consumer, relative to price of
the same basket in some base year. By including a broad range of thousands of
goods and services with the fixed basket, the CPI can obtain an accurate
estimate of the cost of living. It is important to remember that the CPI is not a
dollar value like GDP, but instead an index number or a percentage change from
the base year.

Constructing the CPI

Each month, the Bureau of Labor Statistics publishes an updated CPI. While in
practice this is a rather daunting task that requires the consideration of
thousands of items and prices, in theory computing the CPI is simple.

The CPI is computed through a four-step process.

4.The fixed basket of goods and services is defined. This requires figuring out
where the typical consumer spends his or her money. The Bureau of
Labor Statistics surveys consumers to gather this information.
5.The prices for every item in the fixed basket are found. Since the same basket
of goods and services is used across a number of time periods to
determine changes in the CPI, the price for every item in the fixed basket
must be found for every point in time.
6.The cost of the fixed basket of goods and services must be calculated for each
 time period. Like computing GDP, the cost of the fixed basket of goods
and services is found by multiplying the quantity of each item times its
price.
7.A base year is chosen and the index is computed. The price of the fixed basket
of goods and services for each comparison year is then divided by the
price of the fixed basket of goods in the base year. The result is multiplied
by 100 to give the relative level of the cost of living between the base year
and the comparison years.

Figure %: Goods and Services Consumed in Country B

For example, let's compute the CPI for Country B. In this simplified example,
consumers in Country B only purchase bananas and backrubs (lucky fools). The
first step is to fix the basket of goods. The typical consumer in Country B
purchases 5 bananas and 2 backrubs in a given period of time, so our fixed
basket is 5 bananas and 2 backrubs. The second step is to find the prices of
these items for each time period. This data is reported in the table, above. The
third step is to compute the basket's cost for each time period. In time period 1
the fixed basket costs (5 X $1) + (2 X $6) = $17. In time period 2 the fixed basket
costs (5 X $2) + (2 X $7) = $24. In time period 3 the fixed basket costs (5 X $3) +
(2 X $8) = $31. The fourth step is to choose a base year and to compute the CPI.
Since any year can serve as the base year, let's choose time period 1. The CPI
for time period 1 is ($17 / $17) X 100 = 100. The CPI for time period 2 is ($24 /
$17) X 100 = 141. The CPI for time period 3 is ($31 / $17) X 100 = 182. Since the
price of the goods and services that comprise the fixed basket increased from
time period 1 to time period 3, the CPI also increased. This shows that the cost of
living increased across this time period.

Changes in the CPI over time

As we have just seen, the CPI changes over time as the prices associated with
the items in the fixed basket of goods change. In the example just explored, the
CPI of Country B increased from 100 to 141 to 182 from time period 1 to time
period 3. The percent change in the price level from the base year to the
comparison year is calculated by subtracting 100 from the CPI. In this example,
the percent change in the price level from the base period (time period 1) to time
period 2 is 141 - 100 = 41%. The percent change in the price level from time
period 1 to time period 3 is 182 - 100 = 82%. In this way, changes in the cost of
living can be calculated across time.

Problems with the CPI

While the CPI is a convenient way to compute the cost of living and the relative
price level across time, because it is based on a fixed basket of goods, it does
not provide a completely accurate estimate of the cost of living. Three problems
with the CPI deserve mention: the substitution bias, the introduction of new
items, and quality changes. Let's examine each of these in detail.

Substitution Bias

The first problem with the CPI is the substitution bias. As the prices of goods and
services change from one year to the next, they do not all change by the same
amount. The number of specific items that consumers purchase changes
depending upon the relative prices of items in the fixed basket. But since the
basket is fixed, the CPI does not reflect consumer's preference for items that
increase in price little from one year to the next. For example, if the price of
backrubs in Country B jumped to $20 in time period 4 while the cost of bananas
remained fixed at $3, consumer would likely purchase more bananas and fewer
backrubs. This intuitive phenomenon of consumers substituting purchase of low
priced items for higher priced items is not accounted for by the CPI.

Introduction of New Items

The second problem with the CPI is the introduction of new items. As time goes
on, new items enter into the basket of goods and services purchased by the
typical consumer. For example, if in time period 4 consumers in Country B began
to purchase books, this would need to be included in an accurate estimate of the
cost of living. But since the CPI uses only a fixed basket of goods, the
introduction of a new product cannot be reflected. Instead, the new items, books,
are left out of the calculation in order to keep time period 4 comparable with the
earlier time periods.

Quality Changes
The third problem with the CPI is that changes in the quality of goods and
services are not well handled. When an item in the fixed basket of goods used to
compute the CPI increases or decreases in quality, the value and desirability of
the item changes. For example, if backrubs in time period 4 suddenly became
much more satisfying than in earlier time periods, but the price of backrubs did
not change, then the cost of living would remain the same while the standard of
living would increase. This change would not be reflected in the CPI from one
year to the next. While the Bureau of Labor Statistics attempts to correct this
problem by adjusting the price of goods in the calculations, in reality this remains
a major problem for the CPI.

Problems
Problem : What does the CPI measure?

Solution for Problem 1 >>

Problem :

Figure %: Goods and Services Consumed in Country C

Using the figure above, compute the CPI for Country C in year 1 using year 1 as
the base year.

Solution for Problem 2 >>

Problem : Using figure 1, compute the CPI for Country C in year 2 using year 1
as the base year.

Solution for Problem 3 >>

Problem : What is the percent increase in the price level in Country C from year
1 to year 2?

Solution for Problem 4 >>

Problem : What are 3 problems with CPI?

Solution for Problem 5 >>

ntroduction and Summary

Two of the most important macroeconomic concepts in the popular media are
inflation and unemployment. In fact, it is difficult to read through the business
section of the newspaper or watch the evening news without hearing at least one
of these ideas mentioned.

Why are people so concerned with inflation and unemployment? These

macroeconomic concepts affect every person in the economy. When inflation is
high, prices increase rapidly and interest rates rise. When unemployment is high,
joblessness is high and people are out of work. A report of high inflation or high
unemployment causes concern at some level to most consumers. In short,
inflation and unemployment bear directly upon the wealth and standard of living
of people within the economy.

But how do these concepts fit into the bigger picture of macroeconomics?
Inflation affects the purchasing power of money over time; interest rates, savings,
and consumption are closely tied to the inflation rate both in theory and in
practice. Similarly, the unemployment rate is an important variable in economic
growth and is even linked to the inflation rate. Most importantly, both of these
variables are useful in expressing and comparing the state of the economy to
past and present, yet are simple enough to be accessible to the average
informed consumer.

This SparkNote, in conjunction with the SparkNote on GDP and CPI, provides a
complete basic set of tools for measuring the economy. An understanding of how
these concepts function together to measure the economy provides the
opportunity to see the effects of economic changes that might otherwise get lost
in the noise.

Terms
Base Year  -  The year from which the original quantities and/or prices are taken
in the calculation of an index.
Benefits  -  Non-cash payments made to employees. For instance, health care
plans or pensions.
Bureau of Labor Statistics  -  The government organization responsible for
regularly gathering data about the economic status of the population.
Comparison Year  -  The year for which the quantities and/or prices of goods or
services are replaced by those of the base year in the calculation of an index.
Cost of Living  -  An index based on the amount of money necessary to
purchase the market basket of goods and services purchased by the average
consumer, relative to the same basket in an earlier year.
CPI (Consumer Price Index)  -  The consumer price index is a cost of living
index that is based on a fixed market basket of goods and services purchased by
the average consumer.
Cyclical Unemployment  -  Deviations from the natural rate of unemployment
based on normal fluctuations in the business cycle.
Efficiency Wages  -  Wages paid by a firm to an employee that are above the
market-clearing wage with the intention of keeping the employees healthier,
happier, and of high productivity. Efficiency wages increase unemployment by
creating a surplus of labor at the given wage.
Efficient Market  -  A market where the quantity supplied is equal to the quantity
demanded and the price of goods is set at the equilibrium price.
Employed  -  An individual who is currently working at a job.
Equilibrate  -  Describes the movement of the factors of a market so that the
quantity supplied is equal to the quantity demanded and the price of goods is set
at the equilibrium price.
Equilibrium Wage  -  The wage in the labor market where labor supply is equal
to labor demand and the market clears.
Expected Inflation  -  When economists and consumers plan upon the presence
of inflation, and this expectation is reflected in the economic decisions made by
these groups.
Fixed Basket  -  A set group of goods and services whose quantities do not
change over time. A fixed basket is used in the calculation of the CPI.
Flexible Basket  -  A group of goods and services that changes both in
composition and quantity as consumers' preferences change. A flexible basket is
used in the calculation of the GDP deflator, for instance.
Frictional Unemployment  -  A type of unemployment in which an individual is
between jobs.
Full Capacity  -  When the economy is producing at an output level that
corresponds to the natural rate of unemployment, or about 6%.
Full Employment  -  When the unemployment level is at, or very close to, 6%
(the natural rate of unemployment).
Full Output  -  The level of output that occurs when the labor force is at full
employment.
Gross Domestic Product (GDP)  -  The gross domestic product is the total
value of all goods and services produced in an economy.
GDP Deflator  -  The ratio of the nominal GDP to the real GDP. It shows the
overall price level by comparing the cost of a basket of goods from one year to
the next.
Inflation  -  An increase in the overall price level.
Job Search  -  The active process of looking for a job.
Labor Market  -  The market where firms supply jobs and individuals supply
labor and in which wage is the equilibrating factor.
Labor Unions  -  Groups of workers who rally together to improve the pay and
conditions on the job.
Laspeyres Index  -  An index where the basket of goods is fixed.
Macroeconomic Economy  -  This refers to the economy as a whole, as
opposed to a view of the economy as based on the actions of individual actors.
Market-Clearing Level  -  The level, price, or quantity where supply and demand
are equal.
Menu Costs of Inflation  -  Costs associated with inflation that arise when firms
have to change printed price schedules.
Minimum Wage Laws  -  Government imposed minimum hourly wages that
must be observed. The minimum wage is aimed at providing a minimum
standard of living, but also have the ancillary effect of increasing unemployment.
National Output  -  The total value of goods and services produced by an
economy in a specified time period. Also known as GDP.
Natural Rate of Unemployment  -  The rate of unemployment that the economy
tends to hover around. Most economists believe that this value is around 6%.
Nominal GDP  -  The total value of all goods and services produced in an
economy, valued at current dollar, and not adjusted for inflation.
Nominal Prices  -  Prices of goods and services valued at dollars current when
the goods and services were provided. Nominal prices are not adjusted for
inflation.
Okun's Law  -  This details the inverse relationship between unemployment and
real GDP. Click here to see the Okun's Law Formula.
Out of the Labor Force  -  Describes people who are not employed and are not
currently looking for employment. This includes children and retirees.
Paasche Index  -  An index based upon a flexible basket of goods and services.
Phillips Curve  -  Describes the general inverse relationship between
unemployment and inflation. Click here to see the Phillips Curve Formula.
Potential Output Level  -  The output of an economy when all of the productive
factors, including labor, are used at their normal rate. In terms of unemployment,
this corresponds to a 6% unemployment rate.
Price Level  -  The general cost of items within an economy relative to one
another.
Price of Labor  -  The wage paid to workers.
Production Capability  -  The production level of an economy when all of the
productive factors, including labor, are used at their normal rate. In terms of
unemployment, this corresponds to a 6% unemployment rate.
Purchasing Power  -  The amount of goods and services that a unit of currency
can buy.
Real GDP  -  The total value of all goods and services produced in an economy
valued at constant dollars, or adjusted for inflation.
Real Value  -  The value of something at constant dollars, or adjusted for
inflation.
Shoeleather Cost of Inflation  -  Costs of expected inflation caused by people
having to make more trips to the bank to make withdrawals because they do not
want to keep cash on hand.
Stagflation  -  When inflation and unemployment both increase. This
phenomenon seems to negate the general applicability of the Phillips Curve.
Standard of Living  -  The level of economic well-being that an individual enjoys.
Structural Unemployment  -  Unemployment due to a mismatch between
workers' skills and firms' needs.
Substitute  -  An item that is purchased in lieu of a more expensive or less
desirable item.
Total Labor Force  -  The sum of employed workers and unemployed job
searchers.
Unemployed  -  Describes individuals who are not currently working but are
currently searching for a job.
Unexpected Inflation  -  Inflation that economists and consumers do not expect.
Value of a Dollar  -  The purchasing power of a dollar.
Wage  -  The amount of money paid to a worker.
Formulae
 
[CPI(earlier year) - CPI(later year)] /
Percentage change in the
CPI(earlier year) or [GDP(earlier year) -
price level
GDP(later year)] / GDP(earlier year)
 
Percentage change in real GDP = 3% -
Okun's Law
2(change in the unemployment rate)
 
Unemployment rate =
Unemployment Rate
(unemployed)/(employed + unemployed)
 
Inflation = ((expected inflation) - B) ((cyclical
unemployment rate) + (error))

Phillips Curve
where B equals a number greater than zero
that represents the sensitivity of inflation to
unemployment.

Inflation
Things cost more today than they used to. In the 1920's, a loaf of bread cost
about a nickel. Today it costs more than $1.50. In general, over the past 300
years in the United States the overall level of prices has risen from year to year.
This phenomenon of rising prices is called inflation.

While small changes in the price level from year to year may not be that
noticeable, over time, these small changes add up, leading to big effects. Over
the past 70 years, the average rate of inflation in the United States from year to
year has been a bit under 5 percent. This small year-to-year inflation level has
led to a 30-fold increase in the overall price during that same period.

Inflation plays an important role in the macroeconomic economy by changing the

value of a dollar across time. This section on inflation will deal with three
important aspects of inflation. First, it will cover how to calculate inflation.
Second, it will cover the effects of inflation calculations using the CPI and GDP
measures. Third, it will introduce the effects of inflation.

Calculating inflation
Inflation is the change in the price level from one year to the next. The change in
inflation can be calculated by using whatever price index is most applicable to the
given situation. The two most common price indices used in calculating inflation
are CPI and the GDP deflator. Know, though, that the inflation rates derived from
different price indices will themselves be different.

Calculating Inflation Using CPI

The price level most commonly used in the United States is the CPI, or consumer
price index. Thus, the simplest and most common method of calculating inflation
is to calculate the percentage change in the CPI from one year to the next. The
CPI is calculated using a fixed basket of goods and services; the percentage
change in the CPI therefore tells how much more or less expensive the fixed
basket of goods and services in the CPI is from one year to the next. The
percentage change in the CPI is also known as the percentage change in the
price level or as the inflation rate.

Fortunately, once the CPI has been calculated, the percentage change in the
price level is very easy to find. Let us look at the following example of "Country
B."

Figure %: Goods and Services Consumed in Country B

Over time the CPI changes only as the prices associated with the items in the
fixed basket of goods change. In the example from Country B, the CPI increased
from 100 to 141 to 182 from time period 1 to time period 2 to time period 3. The
percent change in the price level from the base year to the comparison year is
calculated by subtracting 100 from the CPI. In this example, the percent change
in the price level from time period 1 to time period 2 is 141 - 100 = 41%. The
percent change in the price level from time period 1 to time period 3 is 182 - 100
= 82%. In this way, changes in the cost of living can be calculated across time.
These changes are described by the inflation rate. That is, the rate of inflation
from period 1 to period 2 was 41% and the rate of inflation from period 1 to
period 3 was 82%. Notice that the inflation rate can only be calculated using this
method when the same base year is used for all of the CPI's involved.

While it is simple to calculate the inflation rate between the base year and a
comparison year, it is a bit more difficult to calculate the rate of inflation between
two comparison years. To make this calculation, first check that both comparison
years use the same base year. This is necessary to ensure that the same fixed
basket of goods and services is used. Next, to calculate the percentage change
in the level of the CPI, subtract the CPI for the later year from the CPI for the
earlier year and then divide by the CPI for the earlier year.

In the example from Country B, the CPI for period 2 was 141 and the CPI for
period 3 was 182. Since the base year for these CPI calculations was period 1,
we must use the method of calculating inflation that takes into account the
presence of two comparison years. We need to subtract the CPI for the later year
from the CPI for the earlier year and then divide by the CPI for the earlier year.
That gives (182 - 141) / 141 = 0.29 or 29%. Thus, the rate of inflation from period
2 to period 3 was 29%. Notice that this method works for calculating the rate of
inflation between a base year and a comparison year as well. For instance, the
CPI for period 1 was 100 and the CPI for period 2 was 141. Using the formula
above gives (141 - 100) / 100 = 0.41 or 41%.

Calculating Inflation Using the GDP Deflator

The other major price index used to determine the price level is the GDP deflator,
a price index that shows how much of the change in the GDP from a base year is
reliant on changes in the price level. As covered in the previous SparkNote, the
GDP deflator is calculated by dividing the nominal GDP by the real GDP (the
details for calculating the nominal GDP and the real GDP are presented in Part 1
of this SparkNote).

For example, let's calculate, using the table above, the GDP deflator for Country
B in period 3 using period 1 as the base year. In order to find the GDP deflator,
we first must determine both nominal GDP and real GDP in period 3. Nominal
GDP in period 3 is (10 X $2) + (9 X $6) = $74 and real GDP in period 3 using
period 1 as the base year is (10 X $1) + (9 X $6) = $64. The ratio of nominal
GDP to real GDP is ($74 / $64 ) - 1 = 16%. This means that the price level rose
16% from period 1, the base year, to period 3, the comparison year. Thus, the
inflation rate from period 1 to period 3 was 16%. Notice that it is important to use
the earlier year that you want to compare as the base year in the calculation of
real GDP.

CPI vs. GDP Measures of Inflation

The inflation rate calculated from the CPI and GDP deflator are usually fairly
similar in value. In theory, there is a significant difference between the abilities of
each index to capture consumer's consumption choices when a change in price
occurs. The CPI uses a fixed basked of goods from some base year, meaning
that the quantities of goods and services consumed remains the same from year
to year in the eyes of the CPI, whereas the price of goods and services changes.
This type of index, where the basket of goods is fixed, is called a Laspeyres
index.

The GDP deflator, on the other hand, uses a flexible basket of goods that
depends on the quantities of goods and services produced within a given year,
while the prices of the goods are fixed. This type of index, where the basket of
goods is flexible, is called a Paasche index. While both of these indices work for
the calculation of inflation, neither is perfect. The following example will help to
illustrate why.

Let's say that a major disease spreads throughout the country and kills all of the
cows. By dramatically limiting supply, this happenstance would cause the price of
beef products to jump substantially. As a result, people would stop buying beef
and purchase more chicken instead. However, given this situation, the GDP
deflator would not reflect the increase in the price of beef products, because if
very little beef was consumed, the flexible basket of goods used in the
computation would simply change to not include beef. The CPI, on the other
hand, would show a huge increase in cost of living because the quantities of beef
and milk products consumed would not change even though the prices shot way
up.

When the prices of goods change, consumers have the ability to substitute lower
priced goods for more expensive ones. They also have the ability to continue
buying the more expensive ones if they like them enough more than the less
expensive ones. The GDP deflator takes into account an infinite amount of
substitution. That is, because the index is a Paasche index where the basket of
goods is flexible, the index reflects consumers substituting less expensive goods
for more expensive ones. The CPI, on the other hand, takes into account zero
substitution. That is, because the index is a Laspeyres index where the basket of
goods is fixed, the index reflects consumers buying the more expensive goods
regardless of the changes in prices. Thus, the GDP deflator method
underestimates the impact of a price change upon the consumer because it
functions as if the consumer always substitutes a less expensive item for the
more expensive one. On the other hand, the CPI method overestimates the
impact of a price change upon the consumer because it functions as if the
consumer never substitutes. While neither the CPI nor the GDP deflator fully
captures consumers' actions resulting from a price change, each captures a
unique portion of the change.

The Effects of Inflation

There are two general categories of effects due to inflation. The first group of
effects are caused by expected inflation. That is, these effects are a result of the
inflation that economists and consumers plan on year to year. The second group
of effects are caused by unexpected inflation. These effects are a result of
inflation above and beyond what was expected by economics and consumers. In
general, the effects of unexpected inflation are much more harmful than the
effects of expected inflation.

Expected Inflation
The major effects of expected inflation are simply inconveniences. If inflation is
expected, people are less likely to hold cash since, over time, this money looses
value due to inflation. Instead, people will put cash into interest earning
investments to combat the effects of inflation. This can be a bit of a nuisance,
since people need money to take care of business. Thus, if consumers expect
inflation, they are likely to hold less cash and travel more often to the bank to
withdrawal a smaller amount of money. This phenomenon of changed consumer
patterns is called the shoeleather cost of inflation, referring to the fact that more
frequent trips to the bank will lessen the time it takes to wear out a pair of shoes.
The second major inconvenient effect of expected inflation strikes companies
that print the prices of their goods and services. If expected inflation makes the
real value of the dollar fall over time, firms need to increase their nominal prices
to combat the effects of inflation. Unfortunately, this is not always easy, as
changing menus, catalogues, and price sheets takes both time and money. The
problems of this sort are called the menu costs of inflation. Thus, the two major
effects of expected inflation are merely inconveniences in the form of shoeleather
costs and menu costs.

Unexpected Inflation
If the rate of inflation from one year to the next differs from what economists and
consumers expected, then unexpected inflation is said to have occurred. Unlike
expected inflation, unexpected inflation can have serious consequences for
consumers ranging well beyond inconvenience. The major effect of unexpected
inflation is a redistribution of wealth either from lenders to borrowers, or vice
versa. In order to understand how this works, it is important to remember that
inflation reduces the real value of a dollar (the dollar will not buy as much as it
once did). Thus, if a bank lends money to a consumer to purchase a home, and
unexpected inflation is high, the money paid back to the bank by the consumer
will have less purchasing power or real value than it did when it was originally
borrowed because of the effects of inflation. If a bank lends money and inflation
turns out to be lower than expected, then the shoe is on the other foot and the
lender gains wealth, since the money paid back at interest is of more value than
the borrower expected. In volatile circumstances, when inflation seems to be
moving unexpectedly, neither lenders nor borrowers will want to risk the chance
of hurting themselves financially, and this hesitancy to enter the market will hurt
the entire economy.

Problems
Problem :

Figure %: Goods and Services Consumed in Country B

Compute the inflation in Country B from period 1 to period 2.

Solution for Problem 1 >>

Problem : Compute the inflation in Country B from period 1 to period 3.

Solution for Problem 2 >>

Problem : Compute the inflation in Country B from period 2 to period 3, using

period as the base year.

Solution for Problem 3 >>

Problem : Calculate the GDP deflator for Country B in year 3 using year 1 as the
base year.

Solution for Problem 4 >>

Problem : What is the rate of inflation from period 1 to period 3 in the previous
problem?

Solution for Problem 5 >>

Unemployment
Unemployment is a macroeconomic phenomenon that directly affects people.
When a member of a family is unemployed, the family feels it in lost income and
a reduced standard of living. There is little in the realm of macroeconomics more
feared by the average consumer than unemployment. Understanding what
unemployment really is and how it works is important both for the economist and
for the consumer, as it is often discussed.

The Costs of Unemployment

Because most people rely on their income to maintain their standard of living, the
loss of a job will often directly threaten to reduce that standard of living. This
creates a number of emotional problems for the worker and the family. In terms
of society, unemployment is harmful as well. Unemployed workers represent
wasted production capability. This means that the economy is putting out less
goods and services than it could be producing. It also means that there is less
money being spent by consumers, which has the potential to lead to more
unemployment, beginning a cycle. However, in general, while unemployment is
harmful for individuals, there are some circumstances in which unemployment is
both natural and beneficial for the economy as a whole.

Okun's law
We know that when there is unemployment, the economy is not producing at full
output since there are people who are not working. But, what exactly is the
relationship between unemployment and national output or GDP? How much
would we expect the GDP to increase if unemployment fell 1%? These are useful
and important questions to ask when trying to understand the costs of
unemployment.

An economist named Arthur Okun looked at the relationship between

unemployment and national output over the past 50 years. He noticed a general
pattern and stated an equation to explain it. His equation, Okun's Law, relates the
percentage change in real GDP to changes in the unemployment rate. In
particular, the equation states:

% change in real GDP = 3% - 2 x (change in unemployment rate)

This equation basically says that real GDP grows at about 3% per year when
unemployment is normal. For every point above normal that unemployment
moves, GDP growth falls by 2%. Similarly, for every point below normal that
unemployment moves, GDP growth rises by 2%. This equation, while not exact,
provides a good estimate of the effects of unemployment upon output.
For example, let's say a country had an unemployment rate of 8% in one year
and 6% in the next. Using Okun's law, it would be hypothesized that the
percentage change in the real GDP would be 3% - 2 * (-2%) = 7%. Because 2%
fewer people were unemployed the nation produced 7% more output.
Types of Unemployment
While unemployment is a general term that describes people who wish to work
but cannot find jobs, there are actually a number of specific types of
unemployment. Three particular types of unemployment stand out as most
important, frictional unemployment, structural unemployment, and cyclically
unemployment

8.Some people who are not working are simply between jobs. This may be the
result of being hired elsewhere or simply relocating. They are not actively
searching for a job, but instead just waiting to begin their next job. This is
called frictional unemployment because these workers are literally
between jobs.
9.Other workers have a mismatch of skills for the job or geographic area that
they want to work. If a welder is displaced by a robot or if a nuclear
engineer is simply no longer needed in a lab, these workers become
unemployed. This type of unemployment is called structural
unemployment because the structure of the job is incompatible with the
skills offered by the worker.
10. Finally, some workers may be laid off as the economy slows down. These
workers possess the necessary skills, but there is simply not enough
demand for their firms to continue to employ them. This type of
unemployment is called cyclical unemployment because it is attributable to
changes in output due to the cycles of the economy.

Calculating Unemployment

The Bureau of Labor Statistics (BLS) regularly gathers data from 60,000
households to compute a number of macroeconomic figures. One of these
figures is the unemployment rate.

To compute the unemployment rate, the first step is to place people into one of
three categories: employed, unemployed, or out of the labor force. People who
are employed are currently working. People who are unemployed are not
currently working, but are actively searching for a job and would work if they
found a job. People who are out of the labor force are either not currently looking
for a job or would not work if they found a job.

Once people have been placed into the appropriate categories, the total labor
force can be calculated as the total number of workers who are either employed
or unemployed. The unemployment rate is the ratio of the number of people
unemployed over the total number of people in the labor force.

For example, let's say that a survey by the BLS reveals 20 people employed, 5
people unemployed, and 40 people out of the labor force. Then the labor force
would be the sum of the employed plus the unemployed or 20 + 5 = 25 people.
The unemployment rate is the ratio of the unemployed to the total labor force or
(5 / 25) = 20%.

Full Employment and the Natural Rate of Unemployment

The term full employment sounds as though it means everybody is working. And
indeed, full employment refers to an economic situation in which unemployment
is very low. However, when the economy is at full employment there is a still
small amount of normal unemployment. This unemployment exists because
people are always changing between jobs creating frictional unemployment.
Similarly, when new workers enter the labor market, they do not immediately gain
jobs. Instead, they must search for jobs, even if only for a short period of time.
This causes there to be some unemployment even when the economy is
theoretically at full employment.

The natural rate of unemployment is the rate of unemployment that corresponds

to full employment. Economists theorize that this is around 6% unemployment
due to frictional unemployment and structural unemployment. Cyclical
unemployment causes a slight variation above and below this natural rate. In
general, the economy is said to be operating at full capacity when the
unemployment rate is at the nature rate of unemployment. Similarly, when the
unemployment rate is below the natural rate of unemployment, the economy is
said to be operating above full capacity. Finally, when the unemployment rate is
above the natural rate of unemployment, the economy is said to be operating
below full capacity.

The Causes of Unemployment

Now that we have covered the types of unemployment and how to calculate the
unemployment rate, let's go over what causes unemployment. There are four
basic causes of unemployment in a healthy, working economy. These reasons
for unemployment are: minimum wage laws, labor unions, efficiency wages, and
job search. In the real world economy all four of these forces work together to
create the unemployment that is reflected in the unemployment rate.

Minimum Wage Laws

In microeconomics, we learned that in an efficient market, the price of a good
changes to equilibrate the quantity demanded and the quantity supplied (See the
SparkNote on Supply and Demand.) The labor market, in its natural form, is just
like any other market. If there are unemployed workers who want jobs, the price
of labor or the wage will simply drop until all of the labor force is employed. That
is, this would happen if there were not government intervention into the labor
market. In order to help maintain a certain standard of living among all workers,
the government implements a minimum wage, which artificially inflates the wages
of the workers at the bottom of the wage scale above what the firm would
normally pay at equilibrium. This in turn causes the people above the minimum
wage workers to demand more pay and for the people above them to do the
same. Eventually, the minimum wage causes the wages of all workers to
increase above the market-clearing level. When the wage demanded is greater
than the wage offered, workers earn more; but in response firms will cut jobs to
recoup the money they are losing, increasing unemployed workers. Raising the
minimum wage therefore also increases unemployment. (The factors playing into
this dynamic are more closely examined in the microeconomics SparkNote on
Labor Markets.)

Labor Unions
A second, and closely related, cause of unemployment, lies with the actions of
labor unions. Labor unions are collectives of workers who rally together for higher
wages, better working conditions, and more benefits. These unions force firms to
spend more money on each worker, some in the form of wage and some in the
form of benefits. Overall, this has an effect similar to the minimum wage law,
where workers are demanding wages greater than the firms are willing to pay.
Again, this raises the wages of workers above the market clearing level and
creates a situation in which there are more people who want to work at the wage
than there are firms who want to hire at the wage. In this way, labor unions
increase the wages and benefits of workers who are employed, but may
simultaneously increase the number of workers who are unemployed.

Efficiency Wages
A third reason for unemployment is based on the theory of efficiency wages. The
basic idea behind efficiency wages is that firms benefit by paying their workers
above the equilibrium wage, since higher wages produce happier, healthier, and
more productive workers, and may even increase worker loyalty. But, when the
firms pay efficiency wages that are above the equilibrium level, they also create
an excess in the labor supply: more people want to work for the wage than there
are positions. Efficiency wages, like the minimum wage and labor unions,
therefore increase the wages for workers who are employed but also increase
overall unemployment.

Job Search
The fourth cause of unemployment, job search, is unrelated to the labor market.
Instead, it is based on ideas similar to the frictional, structural, and cyclical
unemployment discussed earlier. When a person decides that he wants to work,
he cannot simply become employed. Instead he much find a job. This job search
often takes a bit of time. During the process of looking for the right job, the
person is considered as an unemployed member of the labor force. Simply
looking for a job or moving from one job to the next causes some unemployment.

Unemployment is in reality much more complex than the average consumer

appreciates. For this reason, most people do not understand that some
unemployment in the economy is not a problem. In fact, unemployment of certain
low levels indicate that the economy is functioning neither above nor below its
potential output level, at a sustainable level.

Problems
Problem : List 3 costs of unemployment.

Solution for Problem 1 >>

Problem : Please explain what is meant by Okun's law.

Solution for Problem 2 >>

Problem :

Using Okun's law, determine the percent change in real GDP if the
unemployment rate goes from 8% to 4%.

Solution for Problem 3 >>

Problem : List the 3 major types of unemployment and the 4 major reasons for
unemployment.

Solution for Problem 4 >>

Problem : Find the unemployment rate given that a survey by the BLS reveals
30 people employed 10 people unemployed, and 40 people out of the labor
force.

Solution for Problem 5 >>

The Tradeoff Between Inflation and Unemployment

Okun's Law describes a clear relationship between unemployment and national
output, in which lowered unemployment results in higher national output. Such a
relationship makes intuitive sense: as more people in a nation work it seems only
right that the output of the nation should increase. Building on Okun's law,
another economist, A. W. Phillips, discovered a relationship between
unemployment and inflation. The chain of basic ideas behind this belief follows:
as more people work the national output increases, causing wages to increase,
causing consumers to have more money and to spend more, resulting in
consumers demanding more goods and services, finally causing the prices of
goods and services to increase. In other words, Phillips showed that
unemployment and inflation shared an inverse relationship: inflation rose as
unemployment fell, and inflation fell as unemployment rose. Since two major
goals for economic policy makers are to keep both inflation and unemployment
low, Phillip's discovery was an important conceptual breakthrough, but also
posed a troublesome challenge: how to keep both unemployment and inflation
low, when lowering one results in raising the other?

The Phillips Curve

Phillips' discovery can be represented in a curve, called, aptly, a Phillips curve.

Figure %: The Phillips Curve

It is important to remember that the Phillips curve depicted above is simply an
example. The actual Phillips curve for a country will vary depending upon the
years that it aims to represent.

Notice that the inflation rate is represented on the vertical axis in units of percent
per year. The unemployment rate is represented on the horizontal axis in units of
percent. The curve shows the levels of inflation and unemployment that tend to
match together approximately, based on historical data. In this curve, an
unemployment rate of 7% seems to correspond to an inflation rate of 4% while
an unemployment rate of 2% seems to correspond to an inflation rate of 6%. As
unemployment falls, inflation increases.

The Phillips curve can be represented mathematically, as well. The equation for
the Phillips curve states inflation = [(expected inflation) – B] x [(cyclical
unemployment rate) + (error)] where B represents a number greater than zero
that represents the sensitivity of inflation to unemployment.

While the Phillips curve is theoretically useful, however, it less practically helpful.
The equation only holds in the short term. In the long run, unemployment always
returns to the natural rate of unemployment, making cyclical unemployment zero
and inflation equal to expected inflation.

Problems with the Phillips Curve and Stagflation

In fact, the Phillips curve is not even theoretically perfect. In fact, there are many
problems with it if it is taken as denoting anything more than a general
relationship between unemployment and inflation. In particular, the Phillips curve
does a terrible job of explaining the relationship between inflation and
unemployment from 1970 to 1984. Inflation in these years was much higher than
would have been expected given the unemployment for these years.

Such a situation of high inflation and high unemployment is called stagflation.

The phenomenon of stagflation is somewhat of a mystery, though many
economists believe that it results from changes in the error term of the previously
stated Phillips curve equation. These errors can include things like energy cost
increases and food price increases. But no matter its source, stagflation of the
1970's and early 1980's seems to refute the general applicability of the Phillips
curve.

The Phillips curve must not be looked at as an exact set of points that the
economy can reach and then remain at in equilibrium. Instead, the curve
describes a historical picture of where the inflation rate has tended to be in
relation to the unemployment rate. When the relationship is understood in this
fashion, it becomes evident that the Phillips curve is useful not as a means of
picking an unemployment and inflation rate pair, but rather as a means of
understanding how unemployment and inflation might move given historical data.

Problems
Problem : What relationship does the Phillips curve describe?

Solution for Problem 1 >>

Problem : Explain the chain of events that underlies the relationship between
inflation and unemployment described by the Phillips curve.

Solution for Problem 2 >>

Problem : What is the equation for the Phillips curve?

Solution for Problem 3 >>

Problem : Define stagflation and explain its implications.

Solution for Problem 4 >>

Problem : How is the Phillips curve best used?

Solution for Problem 5 >>

Money

Terms
Bartering  -  The trading of one good for another. This requires the double
Coincidence of wants, a condition met when two individuals each have different
goods that they other wants.
Commodity Money  -  Money that has an intrinsic value, that is, value beyond
any value given to it because it is money. An example of this would be a gold
coin that has value because it is a precious metal.
Compound Interest  -  Interest that is paid on a sum of money where the
interest paid is added to the principal for the future calculation of interest. Click
here to see the Formula.
Consumption  -  The purchase and use of goods and services by consumers.
Currency  -  The form of money used in a country.
Defaulting on the Loan  -  When a borrower fails to repay a loan leaving the
lender without the money loaned.
Demand for Money  -  The amount of currency that consumers use for the
purchase of goods and services. This varies depending mainly upon the price
level.
Equilibrium  -  The state in a market when supply equals demand.
Fiat Money  -  Money that has no intrinsic value, that is, its only value comes
from the fact that a governing body backs and regulates the currency.
Fischer Effect  -  The point for point relationship between changes in the money
supply and changes in the inflation rate.
Inflation  -  The increase of the price level over time.
Interest  -  Money paid by a borrower to a lender for the use of a sum of money.
Interest Rates  -  The percent of the amount borrowed paid each year to the
lender by the borrower in return for the use of the money.
Liquidity  -  The ease with which something of value can be exchanged for the
currency of an economy.
Medium of Exchange  -  An item used commonly to trade for goods and
services.
Money Supply  -  The quantity of money in an economy. In the US this is
controlled through policy by the Fed.
Nominal GDP  -  The total value of all goods and services produced in a country
valued at current prices.
Nominal Interest  -  The percent of the amount borrowed paid each year to the
lender by the borrower in return for the use of the money not taking inflation into
account.
Nominal Value  -  The value of something in current dollars without taking into
account the effects of inflation.
Output  -  The amount of goods and services produced within an economy.
Price Level  -  The overall level of prices of goods and services in an economy.
This is used in the calculation of inflation rates.
Purchasing Power  -  The real value of a dollar. This describes the quantity of
goods and services that can be purchased for a dollar, taking into account the
effects of inflation.
Quantity Theory of Money  -  The theory that says that the value of money is
based on the amount of money in circulation, that is, the money supply.
Real Interest  -  The percent of the amount borrowed paid each year to the
lender by the borrower in return for the use of the money adjusted for inflation.
Real Value  -  The value of something in taking into account the effects of
inflation.
Store of Value  -  A good that holds a value in such a way that its price is fairly
insensitive inflation.
Unit of Account  -  Something that is used universally in the description of
money matters such as prices. The unit of account most commonly used in the
US is the dollar.
Value of Money  -  The purchasing power of the dollar. The amount of goods
and services that can be purchased for a fixed amount of money.
Velocity  -  The speed with which a dollar bill changes hands. The higher the
velocity of money, the quicker that a given piece of currency will be traded for
goods and services.
Wage  -  The amount of money paid to workers by employers valued in current
dollars.
 
M * V = P * Y where M is the money supply, V
is the velocity, P is the price level, and Y is
the quantity of output. P * Y, the price level
multiplied by the quantity of output, gives the
nominal GDP. This equation can be
Velocity of Money rearranged as V = (nominal GDP) / M. It can
also be converted into a percentage change
formula as (percent change in the money
supply) + (percent change in velocity) =
(percent change in the price level) + (percent
change in output).
 
First, calculate the value of the loan, by
adding one to the interest rate, raising it to the
number of years for the loan, and multiplying
Compound Interest
it by the loan amount. Then, to calculate the
amount of interest, simply subtract the
original loan amount from the total due.
 
The real interest rate is equal to the nominal
Real Interest Rate
interest rate minus the inflation rate.

Functions of Money
Try to imagine an economy without money. Without money, it would be almost
impossible to carry out the usual day to day business of life. For instance, if you
wanted to buy a hamburger without cash, you would have to give the restaurant
something else in return. Perhaps you could wash the dishes, or sweep the floor.
Either way, the ability to pay for goods and services with money greatly simplifies
consumer life and eliminates the necessity of bartering goods and services for
other goods and services.

What exactly does money do? Sure, you can buy things with it and save it, but
how does it function within the economy? There are four basic functions of
money:
11. The first is as a medium of exchange.
12. The second is as a unit of account.
13. The third is as a store of value.
14. The fourth is as liquidity.
By understanding each of these functions, it is possible to see how important
money is to the economy.

The most obvious function of money is as a medium of exchange. When you

hand the waiter a five-dollar bill in exchange for your hamburger, you are using
money as a medium of exchange. You might have a hard time paying for your
hamburger with five dollars worth of apples, but if you did, the apples would
serve as a medium of exchange as well. To simplify, a medium of exchange is
something that buyers give to sellers in exchange for goods and services.
Perhaps money's most compelling advantage is that it is a commonly recognized
and universally accepted medium of exchange. This allows anyone with money
to walk into any restaurant with the confidence that the waiter or clerk will take
your cash in exchange for goods or services. This would likely not be the case
with a basket full of apples.
The second function of money, as a unit of account, is rather obvious, but you
may never have considered it before. When you walk into a restaurant, the menu
tells you that a hamburger costs $5 and a steak costs $15. You know what this
means and are able to compare these prices. If, on the other hand, apples and
oranges were used as units of account, comparison between the costs of goods
and services would be much more difficult. Imagine trying to determine what
costs more, a hamburger costing 25 apples or a steak costing 30 oranges. As a
unit of account, money serves as the common base of comparison that people
use to present prices and record debts. Without a common unit of account, these
tasks would be much more difficult.
The third function of money, as a store of value, is one that we all know well.
When you work, you are paid a wage. The portion of that wage that you do not
spend gets saved. By saving money, you are able to spend some now and some
later. In this way, money serves as a store of value, allowing you to trade current
consumption for future consumption. Imagine if you were paid in bananas. Any
bananas that you did not eat or trade immediately would rot, rendering you
unable to enjoy the fruits of your labor at a later time.
The fourth and final function of money, as a means of liquidity, is important for an
economy to move beyond a simple system of bartering. Imagine that you have
30 apples, and you really want a steak. You walk to the local restaurant and ask
the waiter if you can trade 30 apples for a steak. He informs you that they have
plenty of apples, but could use some oranges. Frustrated and hungry, you walk
out of the restaurant. In this example, apples lacked liquidity since they could not
easily be traded for what you wanted. Liquidity describes the ease with which an
item can be traded for something that you want, or into the common currency
within an economy. Money is the most liquid asset because it is universally
recognized and accepted as the common currency. In this way, money gives
consumers the freedom to trade goods and services easily without having to
barter.
Types of Money

Money comes in a number of different forms. In the preceding section, we saw

apples and oranges used as money. When something with intrinsic value, like
precious metals, is used as money, it is called commodity money. It is interesting
to think about the enormous variety of goods that can serve as commodity
money. Basically, anything that can fulfill the four functions of money, to so some
degree, can be used as commodity money.

Barter economies depend on commodity money. When something lacking

intrinsic value is used as money, it is called fiat money. This system only works if
a government backs the fiat money and regulates its production. In most
countries, the cash or currency is a form of fiat money. The advent of fiat money
is a great convenience in many ways-- imagine trying to carry a week's pay in
apples and oranges.

Problems
Problem : Describe the basic functions of money.

Solution for Problem 1 >>

Problem : Describe the basic types of money.

Solution for Problem 2 >>

Problem : Could milk be used as a form of money? Why or why not?

Solution for Problem 3 >>

Problem : Could diamonds be used as a form of money? Why or why not?

Solution for Problem 4 >>

Problem : What element is most important to the successful implementation Of

fiat money?

Solution for Problem 5 >>

Quantity theory of money

Value of money
What gives money value? We know that intrinsically, a dollar bill is just worthless
paper and ink. However, the purchasing power of a dollar bill is much greater
than that of another piece of paper of similar size. From where does this power
originate?

Like most things in economics, there is a market for money. The supply of money
in the money market comes from the Fed. The Fed has the power to adjust the
money supply by increasing or decreasing the number of bills in circulation.
Nobody else can make this policy decision. The demand for money in the money
market comes from consumers.

The determinants of money demand are infinite. In general, consumers need

money to purchase goods and services. If there is an ATM nearby or if credit
cards are plentiful, consumers may demand less money at a given time than they
would if cash were difficult to obtain. The most important variable in determining
money demand is the average price level within the economy. If the average
price level is high and goods and services tend to cost a significant amount of
money, consumers will demand more money. If, on the other hand, the average
price level is low and goods and services tend to cost little money, consumers
will demand less money.

Figure %: Sample money market

The value of money is ultimately determined by the intersection of the money
supply, as controlled by the Fed, and money demand, as created by consumers.
Figure 1 depicts the money market in a sample economy. The money supply
curve is vertical because the Fed sets the amount of money available without
consideration for the value of money. The money demand curve slopes
downward because as the value of money decreases, consumers are forced to
carry more money to make purchases because goods and services cost more
money. Similarly, when the value of money is high, consumers demand little
money because goods and services can be purchased for low prices. The
intersection of the money supply curve and the money demand curve shows both
the equilibrium value of money as well as the equilibrium price level.

Figure %: Sample shift in the money market

The value of money, as revealed by the money market, is variable. A change in
money demand or a change in the money supply will yield a change in the value
of money and in the price level. Notice that the change in the value of money and
the change in the price level are of the same magnitude but in opposite
directions. An increase in the money supply is depicted in Figure 2. Notice that
the new intersection of the money supply curve and the money demand curve is
at a lower value of money but a higher price level. This happens because more
money is in circulation, so each bill becomes worth less. It takes more bills to
purchase goods and services, and thus the price level increases accordingly.

The quantity theory of money is based directly on the changes brought about by
an increase in the money supply. The quantity theory of money states that the
value of money is based on the amount of money in the economy. Thus,
according to the quantity theory of money, when the Fed increases the money
supply, the value of money falls and the price level increases. In the SparkNote
on inflation we learned that inflation is defined as an increase in the price level.
Based on this definition, the quantity theory of money also states that growth in
the money supply is the primary cause of inflation.

Velocity

While the relationship between money supply, money demand, the price level,
and the value of money presented above is accurate, it is a bit simplistic. In the
real world economy, these factors are not connected as neatly as the quantity
theory of money and the basic money market diagram present. Rather, a number
of variables mediate the effects of changes in the money supply and money
demand on the value of money and the price level.

The most important variable that mediates the effects of changes in the money
supply is the velocity of money. Imagine that you purchase a hamburger. The
waiter then takes the money that you spent and uses it to pay for his dry
cleaning. The dry cleaner then takes that money and pays to have his car
washed. This process continues until the bill is eventually taken out of circulation.
In many cases, bills are not removed from circulation until many decades of
service. In the end, a single bill will have facilitated many times its face value in
purchases.

Velocity of money is defined simply as the rate at which money changes hands. If
velocity is high, money is changing hands quickly, and a relatively small money
supply can fund a relatively large amount of purchases. On the other hand, if
velocity is low, then money is changing hands slowly, and it takes a much larger
money supply to fund the same number of purchases.

As you might expect, the velocity of money is not constant. Instead, velocity
changes as consumers' preferences change. It also changes as the value of
money and the price level change. If the value of money is low, then the price
level is high, and a larger number of bills must be used to fund purchases. Given
a constant money supply, the velocity of money must increase to fund all of these
purchases. Similarly, when the money supply shifts due to Fed policy, velocity
can change. This change makes the value of money and the price level remain
constant.

The relationship between velocity, the money supply, the price level, and output
is represented by the equation M * V = P * Y where M is the money supply, V is
the velocity, P is the price level, and Y is the quantity of output. P * Y, the price
level multiplied by the quantity of output, gives the nominal GDP. This equation
can thus be rearranged as V = (nominal GDP) / M. Conceptually, this equation
means that for a given level of nominal GDP, a smaller money supply will result
in money needing to change hands more quickly to facilitate the total purchases,
which causes increased velocity.

The equation for the velocity of money, while useful in its original form, can be
converted to a percentage change formula for easier calculations. In this case,
the equation becomes (percent change in the money supply) + (percent change
in velocity) = (percent change in the price level) + (percent change in output).
The percentage change formula aids calculations that involve this equation by
ensuring that all variables are in common units.

The velocity equation can be used to find the effects that changes in velocity,
price level, or money supply have on each other. When making these
calculations, remember that in the short run, output (Y), is fixed, as time is
required for the quantity of output to change.

Let's try an example. What is the effect of a 3% increase in the money supply on
the price level, given that output and velocity remain relatively constant? The
equation used to solve this problem is (percent change in the money supply) +
(percent change in velocity) = (percent change in the price level) + (percent
change in output). Substituting in the values from the problem we get 3% + 0% =
x% + 0%. In this case, a 3% increase in the money supple results in a 3%
increase in the price level. Remember that a 3% increase in the price level
means that inflation was 3%.

In the long run, the equation for velocity becomes even more useful. In fact, the
equation shows that increases in the money supply by the Fed tend to cause
increases in the price level and therefore inflation, even though the effects of the
Fed's policy is slightly dampened by changes in velocity. This results a number of
factors. First, in the long run, velocity, V, is relatively constant because people's
spending habits are not quick to change. Similarly, the quantity of output, Y, is
not affected by the actions of the Fed since it is based on the amount of
production, not the value of the stuff produced. This means that the percent
change in the money supply equals the percent change in the price level since
the percent change in velocity and percent change in output are both equal to
zero. Thus, we see how an increase in the money supply by the Fed causes
inflation.

Let's try another example. What is the effect of a 5% increase in the money
supply on inflation? Again, we being by using the equation (percent change in the
money supply) + (percent change in velocity) = (percent change in the price
level) + (percent change in output). Remember that in the long run, output not
affected by the Fed's actions and velocity remains relatively constant. Thus, the
equation becomes 5% + 0% = x% + 0%. In this case, a 5% increase in the
money supply results in a 5% increase in inflation.

The velocity of money equation represents the heart of the quantity theory of
money. By understanding how velocity mitigates the actions of the Fed in the
long run and in the short run, we can gain a thorough understanding of the value
of money and inflation.

Problems
Problem : Describe the money market.

Solution for Problem 1 >>

Problem : Draw a diagram depicting the money market.

Solution for Problem 2 >>

Problem : Describe what happens to the value of money and the money market
when the Fed increases the money supply. Diagram the change.

Solution for Problem 3 >>

Problem : Describe the quantity theory of money.

Solution for Problem 4 >>

Problem : How are the velocity of money, the money supply, and the nominal
GDP related?

Solution for Problem 5 >>

Interest Rates
Mechanics of Interest
When you deposit money into a bank, the bank uses your money to give loans to
other customers. In return for the use of your money, the bank pays you interest.
Similarly, when you purchase something with a credit card, you pay the credit
card company interest for using the money that paid for your purchase. In
general, interest is money that a borrower pays a lender for the right to use the
money. The interest rate is the percent of the total due that is paid by the
borrower to the lender.

The calculation of compound interest is rather simple. To calculate the value of a

loan, add one to the interest rate, raise it to the number of years for the loan, and
multiply it by the loan amount. For example if you borrow $10,000 at 8% per
year, in one year you would owe $10,000 * (1.08 ^ 1) = $800 in interest. To
calculate the amount of interest, simply subtract the original loan amount from
the total due. In this example, the interest due would be $10,800 - $10,000 =
$800.

Reasons for Paying Interest

Why do people pay interest? Lenders demand that borrowers pay interest for
several important reasons. First, when people lend money, they can no longer
use this money to fund their own purchases. The payment of interest makes up
for this inconvenience. Second, a borrower may default on the loan. In this case,
the borrower fails to pay back the loan and the lender loses the money, less
whatever can be recovered from the borrower. Interest helps to make the risk of
default worth taking. In general, the more risk there is of default on the loan, the
higher the interest rate demanded by the lender. Finally, and most importantly,
lenders demand interest since while the borrower has the money, inflation tends
to reduce the real value, or purchasing power, of the loan. In this case, interest
allows the balance due to grow as inflation erodes the real value of the balance
due.

Real vs. Nominal Interest Rates

We learned above that the third and most important reason why lenders demand
interest is that inflation tends to decay the real value of loans over time. For
example, let's say a loan is made for $10,000, inflation is 5%, and the loan is paid
back after one year. When the loan is made, it can purchase $10,000 worth of
goods, such as a compact car. After a year of inflation at 5%, the same compact
car costs $10,500. At the same time, one year later, the $10,000 loan is repaid in
full. Unfortunately, due to inflation, the real value, or purchasing power, of the
money when the loan is repaid is $500 less than when it was made.

By charging an interest rate at least equal to the rate of inflation, this problem is
corrected. For example, say a loan is made for $10,000 at 5% interest, inflation is
5%, and the loan is paid back after one year. When the loan is made, it can
purchase $10,000 worth of goods, such as a compact car (again). After a year of
inflation at 5%, the same compact car costs $10,500. At the same time, one year
later, the loan is repaid in full plus interest, totaling $10,500. In this case, the
effects of inflation and the interest rate counteract each other so that the real
value of the money stays the same even though the nominal value of the money
increases by $500.

Two different interest rates are used in the discussion of loans. The nominal
interest rate is the interest rate reported when a loan is made. This rate does not
take into account the effects of inflation. The real interest rate is not usually
reported when a loan is made. This rate takes into account the effects of inflation
on the purchasing power of money repaid from a loan.

There is a relationship between the nominal interest rate, the real interest rate,
and the rate of inflation. The real interest rate is equal to the nominal interest rate
minus the inflation rate; the real interest rate, or the purchasing power of the
loan, is equal to the interest earned less the effect of inflation. In the problem
above, the nominal interest rate was 5%, the inflation rate was 5%, and thus,
using the equation, the real interest rate was 0%. In this case, the lender
received no protection from default or payment for the inconvenience of having
the money unavailable. In general, lenders always charge a nominal interest rate
greater than the expected inflation rate.

Fischer Effect
The nominal interest rate is what is paid on the balance due on a loan. If the
equation presented above is rearranged, we see that the nominal interest rate is
equal to the real interest rate plus the inflation rate. In the previous section on the
quantity theory of money, we learned that when the Fed increases the money
supply, the major effect is an increase in the inflation rate.

From the equation just presented, we learn a second effect of an increase in the
money supply. Because the nominal interest rate is equal to the real interest rate
plus the inflation rate, an increase in the inflation rate due to an increase in the
money supply by the Fed results in an increase in the nominal interest rate. This
increase is affected by lenders to ensure that they receive the real interest rate
they wanted on the loan, regardless of the effects of inflation. The point for point
adjustment of the nominal interest rate to the real interest rate is called the
Fischer effect.

Problems
Problem : Why do lenders require borrowers to pay interest?

Solution for Problem 1 >>

Problem : How much would be due on a $20,000 loan at 6% interest after 3

years?

Solution for Problem 2 >>

Problem : How does the nominal interest rate differ from the real interest rate?

Solution for Problem 3 >>

Problem : What is the equation that represents the real interest rate? What does
this equation show?

Solution for Problem 4 >>

Problem : Explain the Fischer effect.

Solution for Problem 5 >>

BANKING

Introduction and Summary

You work after school and earn $200 per week. On payday, you take your check
to the bank and cash it. You put part of the money in a savings account and you
put the rest in a checking account. After a number of months, you decide to
purchase a car, using your money in savings plus interest and a loan from the
bank.

This situation seems normal enough, but this commonly utilized chain is more
complex than it would appear on the surface. It also raises some important
questions. How are banks able to take money and make loans? Do banks always
have enough currency in their vaults to cover the deposits? If not, where does
the currency go? How do banks get money in the first place? These questions
will be addressed in the following SparkNote.

In the SparkNote on money and interest rates, we learned that there is less
currency in the economy than is necessary to fund all of the purchases that occur
in a given period of time. This means that bills must change hands many times to
make the economy turn. In effect, there is much more wealth in the economy
than there is currency to cover it. How is this wealth created? Furthermore, how
much more money moves through the economy than there is currency to cover
all transactions? This SparkNote will cover the topic of banking. Banks fit into the
economy in a number of ways that are not necessarily apparent. We will go over
these intricacies and some that are particular to the American banking system.
Terms
100% Reserve Banking System  -  A system in which banks must keep all
deposits on hand and ready for withdrawal.
Assets  -  Cash, stocks, bonds, and physical goods that are stores of wealth and
value.
Balance Sheet  -  An accounting tool where assets and liabilities are compared
side by side.
Borrowers  -  Individuals who take out loans from banks.
Currency  -  Money, either fiat or commodity, that is commonly used in an
economy.
Demand Deposits  -  Deposits made by in banks that can be withdrawn at any
time--that is, on demand.
Deposits  -  Money given to banks for safekeeping and to earn interest.
Federal Deposit Insurance Corporation  -  A corporation that insures individual
bank accounts up to $100,000 to ensure that the public is confident in the
banking system.
Federal Funds Interest Rate  -  The discount interest rate at which the branch
banks of the Fed loan money to other banks.
Federal reserve  -  The federal group that controls the money supply though
monetary policy and fiscal policy.
Federal Reserve Banks  -  Branches of the Fed that serve as banks for non-
government controlled banks by accepting deposits, giving withdrawals, and
making loans as needed.
Fiat Money  -  Money that has no intrinsic value but that is instead only valuable
because it is backed and regulated by a governing body.
Financial Intermediary  -  An entity, like a bank, that works between savers and
borrowers by accepting deposits and making loans.
Fiscal Policy  -  Operations by the Fed that affect the money supply including
manipulation of the federal funds interest rate and the reserve requirement.
Fractional Reserve Banking System  -  A banking system wherein less than
100% of the deposits are required to be held as reserves.
Government Bonds  -  Bonds issued by the government and bought and sold by
the Fed as a form of monetary policy to manipulate the money supply.
Inflation  -  An increase in the price level over time.
Interest  -  Money paid by a borrower to a lender in return for the use of money
in the form of a loan.
Interest Rate  -  The rate of interest in the form of percent of the balance due per
year.
Lender  -  One who gives money to be repaid at a later date, with interest.
Liabilities  -  Money owed.
Loans  -  Money given by lenders to borrowers.
Monetary Policy  -  Policy used to affect the money supply employed by the
Fed. In particular, this describes the open market operations of buying and
selling government bonds.
Money  -  The stock of assets used in transactions within an economy.
Money Multiplier  -  The number that describes the change in the money supply
given an initial deposit and a reserve requirement.
Money Supply  -  The total amount of currency in circulation as controlled by
Fed policy.
Open Market Operations  -  The purchase and sale of government bonds by the
Fed in order to affect the money supply.
Paper Balances  -  Deposits that exist on paper but are not backed by physical
currency.
Principle  -  The initial amount of money given as a loan.
Reserve  -  Money not given out in loans that is available for repaying depositors.
Reserve Requirement  -  The percent of total deposits required to be held back
for repaying depositors. This is controlled by the Fed as a form of monetary
policy.
Savers  -  Individuals who deposit money in banks.
Treasury  -  The government agency that prints, mints, and stores money.
Formulae
Money Multiplier = 1 / (reserve requirement)  - 
Change in Money Supply = [initial deposit * (1 / reserve requirement)] -
initial deposit  - 

Purpose of Banks
Business of banks
What do banks do? We know that most banks serve to accept deposits and
make loans. They act as safe stores of wealth for savers and as predictable
sources of loans for borrowers. In this way, the major business of banks is that of
a financial intermediary between savers and borrowers. The bank simplifies this
process by eliminating the need for savers to find the right borrowers and the
right time to directly make a loan.

Banks are generally trusted by the public. When people put their savings into
banks, they receive little more than a paper receipt in return. There are two
organizations in place to ensure that banks are trustworthy with individuals'
money and reasonable in the loans that they make. The Federal Deposit
Insurance Corporation guarantees that deposits, up to $100,000 per account, will
be returned to the depositor, even if the bank fails. Individual banks also have a
board of directors to regulate the sizes and interest rates of loans the bank
makes. This board is charged with ensuring that the bank is taking reasonable
risks with its depositors' money.

Banks serve another important role. When you look at a check or a debit card
you will usually see the name of a bank. Individual banks serve as the issuing
and regulating bodies for many financial services often employed by consumers.
In this way, banks are able to give depositors access to their money while also
maintaining a large number of loans.

What happens when you deposit money into a bank? First, the money is
recorded (usually by computer) and added to your account. It is then placed into
the vault. At various times during the day, money is removed from the vault and
taken to a second bank. This bank, unlike the first, does not serve individuals. It
is a "banks' bank," usually a branch of the Federal Reserve. The first bank is able
to make deposits, withdrawals, and take out loans from the second bank.

When you walk into a bank to withdraw money or to take out a loan, the reverse
of the process outlined above occurs. If the first bank does not have enough
money in the vault to cover the withdrawal or the loan, the first bank goes to the
second bank and withdraws money. If the first bank does not have enough
money in its account at the second bank, then it must take out a loan at a lower
rate of interest than the loan that it will eventually give to the individual borrower.
In this way, a bank is able to accept deposits, honor withdrawals, and make
loans without having to maintain all of the deposited cash on hand in the vault.

How do banks make money? As financial intermediaries, they earn enough to

support their activities by the difference between the interest rate paid to savers
and the interest rate charged on loans. When customers make deposits in a
savings account, they earn interest on the principle. Similarly, when customers
take out loans, they pay interest on the principle. By charging the borrower a
slightly higher interest rate than that which is given to the depositor, a bank is
able to cover its expenses.

Creation of money

Banks serve another very important purpose involving the creation of money. To
begin, let's go to a simplified world where banks only serve as a safe place to
store money. They do not make loans and do not pay interest. Also, let's say that
the money supply is only $1000. In this case, if a bank held $100 in deposits, the
money supply would simply be $900 since the $100 in the bank would no longer
be in circulation. When the depositor withdrew the $100 deposit and spent it, the
money supply would again increase to $1000. This system is called a 100\%
reserve banking system because a bank holds 100% of all of the deposits made.

In the real world though, banks are required to hold significantly less than 100%
of the deposits in reserve. A bank can make loans, which are then redeposited,
and can then be loaned out again; this, in essence, creates money. In this way,
any banking system with less than 100% required reserves effectively increases
the money supply. This system is called fractional reserve banking because
banks hold less than 100% or a fraction of the deposits in reserve.

For example, let's say that an economy has a money supply equal to $1000 and
that there is a reserve requirement of 50%. If all $1000 is deposited into a bank,
half of this amount must be held as reserves to cover withdrawals and half of this
amount can be used to make loans. Say the bank gives out $500 in loans. The
money is spent and eventually redeposited in the bank. Now, the bank has
$1500 deposited. Only $1000 of this amount is in currency. The other $500 is
owed to the bank and exists in a form known as a paper balance. The bank has
$1500 in deposits, and since it is required to keep half in reserves, it must keep
$750 in currency. This leaves only $250 in currency available for loan seekers.
This process continues and real balances are replaced by paper balances until
the bank can no longer make loans because all of its currency must be kept in
real balances.

This action by banks can also be illustrated using a balance sheet procedure. A
balance sheet is an accounting tool that lists assets and liabilities. For a bank,
reserves and loans serve as assets because they are money that the bank has,
or has coming. Deposits, on the other hand, are liabilities; they are money that
the bank owes. When creating a balance sheet, the assets are listed on the left
and the liabilities are listed on the right.

Figure %: Balance Sheet for a Bank

We can model the example of fractional reserve banking presented above using
a balance sheet procedure. This is done in figure 1. To begin, list the assets and
the liabilities of the bank after $1000 is deposited and $500 is loaned out.
Remember that the reserve rate is 50%, so $500 must be held back in reserves
and the rest may be loaned out. Given that this money is deposited into the bank
again rather than stored in a mattress, the liability of deposits increases by $500
to $1500 while the reserves increase by $250 to $750. The bank now has $250
with which to make loans. Given that it loans out the entire amount, which is then
deposited again, the liability of deposits increases by $250 to $1750.
Furthermore, the assets of loans increase to $750 and the assets of reserves
increase to $875. This process continues until the reserve amount is equal to the
total amount of the money supply. Until that time, each loan that is made and
redeposited increases the money supply.
Money multiplier
The process of money creation by banks continues until no more loans can be
made due to reserve requirements. Each time a loan is made and redeposited,
the possible amount of next loan shrinks. There is an easy way to determine the
total money supply created by an initial deposit. Simply multiply the initial deposit
by one over the reserve rate. Then, to find the amount of money created by the
bank, simply subtract the initial deposit from this figure.

For example, say that $2000 is initially deposited into a bank and the reserve
requirement is 20%. What is the change in the money supply created by this
deposit? First multiply the initial deposit by one over the reserve rate. This gives
$2000 * (1 / .2) = $10,000. Then, subtract the initial deposit: $10,000 - $2000 =
$8000. Thus, a $2000 deposit yielded an $8000 change in the money supply.

Clearly, there are many jobs and purposes for banks. By creating money, banks
serve to facilitate many transactions with a relatively small initial money supply.
By holding deposits and making loans, banks fulfill the needs of consumers and
producers. In this way, banks are more than just financial intermediaries. Banks
are in fact crucial to the functioning of the economy.

Problems
Problem :

What is the major service provided by banks?

Solution for Problem 1 >>

Problem :

What happens when you deposit money in a bank?

Solution for Problem 2 >>

Problem :

How do banks earn money?

Solution for Problem 3 >>

Problem :

Explain the advantage of fractional reserve banking.

Solution for Problem 4 >>

Problem :

What is the change in the money supply created by an initial deposit of $2000 if
the reserve requirement is 20%?

Solution for Problem 5 >>

Central Banking System

Money supply
In the SparkNote on money and interest rates we learned about the money
supply. Initially we defined the money supply as the total amount of currency held
by the public. While this definition is correct, it is incomplete. In the previous
section, we learned that through a fractional reserve banking system, the money
supply increases. Thus, the money supply is better defined as the total amount of
currency plus deposits held by the public. All available money, either in terms of
currency or demand deposits, is thus accounted for.

Initially, money supply was introduced as a vertical line that was only affected by
Fed policies. While it is true that the Fed has the majority of the control over the
money supply, our new definition of money supply indicates that the public has
so me control as well, albeit unwitting: the public has the power to make deposits
and take out loans. We will work through how both the Fed and the public affect
the money supply through their actions.

There are three basic ways that the Fed can affect the money supply. The first is
through open market operations. The second is by changing the reserve
requirement. The third is through changing the federal funds interest rate. Each
of the se actions in some way affects the total amount of currency or deposits
available to the public.

Open market operations are a form of monetary policy, meaning that the Fed
directly affects the money supply. Open market operations are the sale and
purchase of government bonds issued and regulated by the Fed. When the Fed
sells government bon ds, the public exchanges currency for bonds, thus resulting
in a shrinking of the money supply. When the Fed purchases government bonds,
the Fed exchanges currency for bonds, thus resulting in an increase in the
money supply. Open market operations are the most common tool that the Fed
uses to affect the money supply. In fact, almost every weekday government
bonds are bought and sold in New York City.

The second way that the Fed can influence the money supply is through
changing the reserve requirements. This is a form of fiscal policy because the
Fed is working with the finances of banks to affect the money supply rather than
with the money suppl y directly. We learned in the section on the purpose of
banksthat the money multiplier shows how much an initial deposit increases the
money supply after loans are made and redeposited. Recall that the money
multiplie r is one over the reserve requirement. Thus, if the reserve requirement
is decreased, banks are required to hold fewer reserves and can then make
more loans. This in turn repeats the cycle of loan to deposit, resulting in an
increase in the money supply . For a given initial deposit, a smaller reserve
requirement will result in a larger money multiplier, and thus in a larger change in
the money supply.

The third way that the Fed can influence the money supply is through changing
the federal funds interest rate. This is also a form of fiscal policy because the Fed
is working with the finances of banks to affect the money supply rather than with
the mone y supply directly. We learned in the section on the purpose of banks
that banks make deposits, withdrawals, and loans from banks' banks that are
usually branches of the Fed. When a bank makes many loans, its reserves get d
epleted to near the absolute required minimum. If a customer makes a
withdrawal, banks must either recall a loan or take out a loan to pay the
withdrawal while still maintaining the necessary reserves. If the Fed increases
the federal funds interest rate, banks will be less likely to borrow money from the
Fed and will thus be more weary of making loans to ensure that they have the
necessary reserve requirements. Thus, if the federal funds interest rate is higher,
banks make fewer loans, the money multi plier is not fully utilized, and the
change in the money supply for a given initial deposit is smaller.

Banking in the US

In the US, the banking system is rather complex, yet highly effective. The first
part of the US banking system is the treasury. The treasury prints, mints, and
stores currency. The next part of the US banking system is the Fed. The Fed
buys and se lls government bonds, changes the federal funds interest rate, and
changes the reserve requirements. The Fed has the greatest control over the
money supply. The next part of the US banking system is the Federal Reserve
Banks. These are banks' banks where banks make deposits, withdrawals, and
loans. In return, the Federal Reserve Banks check the reserve requirements of
the other banks and allow the Fed to implement changes to the money supply
through the federal funds interest rate. The final part of the US banking system
comprises all of the other non-government banks, savings and loans, and credit
unions. These are the banks that the public uses. The interdependent hierarchy
that is established through the central banking system in the US allo ws the
money supply and inflation to be carefully controlled, as well as the fiat money to
maintain value over time.

There are a number of safeguards built into the US banking system. The first is
the Federal Deposit Insurance Corporation. The FDIC insures individual deposits
up to $100,000 in the case of a bank collapse. This measure is supposed to
inspire confidence in the public that the money it deposits in a bank will not be
lost, despite unforeseen events. A second safety measure is a system of bank
checks and audits by the government to ensure that prudent banking practices
are being observed. These are simply very detailed examinations of bank
records and dealings. The third safeguard is the regular verification that banks'
holdings meet reserve requirements. In this way, banks are prepared to pay
depositors as needed and may be able to avoid a bank f ailure. The fourth safety
measure is that banks are limited in the investments that they may make with
deposited funds. Banks not only earn money from interest on loans, but they also
invest money in bonds and stocks. By regulating the amount of risk t hat a bank
can undertake in its investments, the government ensures that depositors' money
will be relatively secure, even in the case of poor economic conditions. In all, the
government regulates the actions of banks in such a way as to maintain the US
banking system as one of the safest and most open in the world.

Problems
Problem :

What is the complete definition of the money supply?

Solution for Problem 1 >>

Problem :

What are the three ways that the Fed can influence the money supply?

Solution for Problem 2 >>

Problem :
How does the Fed affect the money supply through open market operations?

Solution for Problem 3 >>

Problem :

How does the Fed affect the money supply by changing the reserve
requirement?

Solution for Problem 4 >>

Problem :

What are the four major safeguards in the US banking system?

Solution for Problem 5 >>

Economic Growth

Summary
The real gross domestic product (GDP) growth rate since 1970 has averaged
around 3% per year. Over the last 30 years this corresponds to a 242% increase
in the real GDP. The economy has clearly grown during this period. Interestingly,
the actual year-to-year growth rate of real GDP is highly inconsistent. In 1985,
real GDP grew by almost 7%. But in 1982, just a few years earlier, it fell by nearly
2%. There are evidently many factors that affect how the economy grows over
time. But what makes the economy grow? Why does the economy grow at
different rates, seemingly in fits and starts? What affects how the economy grows
over the long term?

When the economy grows, what happens to the standard of living? If price levels
increase significantly, then the nominal GDP may increase but the real GDP is
unchanged. For economic growth to be helpful to the population, the price level
must remain relatively unchanged. In other words, the real GDP must increase.
When the economy can grow significantly and inflation is held stable, the
increased income is spread to the population. This often results in an increase in
the standard of living. An increase in the standard of living entails that people are
better off because they have more money to spend on goods and services sold
at a relatively stable price level. What are the factors that lead to an increased
standard of living? How are increases in the real GDP spread to the population?

When a number of economies are examined over time, an interesting

phenomenon becomes evident. Groups of countries seem to converge in terms
of real GDP per capita. Instead of the rich getting richer and the poor getting
poorer, in terms of economies, similarly organized economies approach one
another in the long run. What are the factors that allow this to occur? How can an
economic advisor help a country to converge with others?

This SparkNote will cover the topic of economic growth. Within and between
economies, economic growth is very important because it directly affects the
wellbeing of the people involved in these economies. This SparkNote will
introduce the important factors in economic growth over time as well as in the
phenomenon of convergence. Through a grounding in these subjects, a better
understanding of how the economy grows over time is within reach.
Terms
Capital  -  Physical and intellectual property that is utilized by labor in the
production of goods and services.
Capital Expenditure  -  Money spent on increasing the amount of capital in a
firm or an economy.
Capital Stock  -  The total amount of capital in an economy or in a firm.
Convergence  -  The theory that all industrialized countries tend to approach one
another over time in terms of GDP per capita.
GDP per Capita  -  Nominal GDP divided by the total population. This indicates
the amount of a country’s total output that each member of the population
theoretical has access to.
Golden Rule Level of Capital  -  The level of capital where consumption and
savings are optimized.
Growth Level  -  The long term rate of growth.
Growth Rate  -  The short term rate of growth.
Human Capital  -  Intellectual property, like education and scientific discoveries,
that affects the level of output in a firm or country.
Industrialized  -  Describes countries that have an infrastructure and
government amenable to industrial development.
Infrastructure  -  Physical machinery and transportation that is in place to aid in
industrialization.
International Market  -  The market for goods and services that spans countries.
Labor  -  Workers who utilize capital to produce output.
Labor Productivity Growth  -  An increase in the amount of output a given unit
of labor can produce.
Nominal GDP  -  The total currency value of all goods and services produced in
a national economy.
Open Market  -  A market for the sale and purchase of goods and services in
which all countries may compete.
Output  -  Goods and services produced by firms.
Physical Capital  -  Machinery used by labor in the production of goods and
services.
Production  -  The creation of output.
Production Capabilities  -  The capital that allows a given amount of potential
output.
Productivity  -  The ability to produce output.
Prosperity  -  The creation of a high standard of living.
Savings Rate  -  The percentage of total income that is saved for future
consumption.
Standard of living  -  The level of economic wellbeing enjoyed by members of a
population.
Technological Progress  -  The advancement of technology over time due to
scientific discoveries.
Trade  -  The purchase and sale of goods and services between entities.
Unemployment  -  The condition of being without a job but also actively
searching for one.
Wage  -  Money paid or received in exchange for labor.

Labor productivity growth

Increasing productivity
When looking at what makes an economy grow in the long run, it is imperative to
begin by examining how output is created. Firms use a combination of labor and
capital to produce their output. Labor consists of the workers and employees who
produce, manage, and process production. Capital describes both the ideas
needed for production and the actual tools and machines used in production.
Ideas and other intellectual property are called human capital. Machinery and
tools are called physical capital.

Firms use some combination of labor and capital to produce output. In particular,
the labor utilizes the capital in the production process. For example, when
making cars, workers use tools and an assembly line to produce a finished
product. The workers are the labor and the machines are the capital.

In order to increase productivity, each worker must be able to produce more

output. This is referred to as labor productivity growth. The only way for this to
occur is through an in increase in the capital utilized in the production process.
This increase can be in the form of either human capital or physical capital.

An example will help to illustrate the basic way that labor productivity growth
works through increases in the capital stock. Say there is a riveter named Joe.
Joe works in a factory that makes metal boxes that are riveted together. He has a
riveting tool that can rivet at a rate that allows Joe to finish 4 metal boxes every
hour. Joe's labor productivity is thus 4 boxes per hour. One day, Joe gets a
second riveting tool. With two tools, Joe can produce 8 metal boxes every hour.
Now Joe's labor productivity has increased from 4 boxes per hour to 8 boxes per
hour. The increase in the physical capital available to Joe, that is, a second tool,
allowed this increase in Joe's labor productivity. For every hour of work Joe puts
in, he can produce 100% more output due to an increase in the physical capital
available to him.

Another example may also be of use. Say there is a chef named Susan. Susan
can cook 10 hamburgers in an hour. One day, she decides to go to the
Hamburger Cooking School to learn how to cook hamburgers faster. When she
returns to work, she is able to cook 40 hamburgers per hour by utilizing the new
tricks she learned. By attending the cooking school, Susan increased her human
capital and thus increased her labor productivity.

It is important to remember that increases in capital can take the form of both
quantity and quality increases. From these two examples, it is clear that the only
way to achieve labor productivity growth is to increase the amount of capital,
physical and/or human, available to workers. And in the long run, the only way for
overall productivity to increase is though increases in the capital used in
production.

Growth level vs. growth rate

When discussing growth, there is an important distinction that must be made.

The growth level is the starting value of whatever is growing; the growth rate is
the change in the growth level from year to year. These distinctions allow for
accurate descriptions of economic policies on long-run growth.

An example will help to illustrate the level vs. rate distinction. Let's use the idea of
capital presented in the preceding section. Say a company owns 50 riveting tools
like the one used by Joe. In order to increase output, the company decides to
purchase 5 new riveting tools next year. In this case, the level of capital is 50
because this is the amount that the firm began with. The growth rate of capital is
10% because from one year to the next the amount of capital used by Joe's firm
increased by 10%.

Changes in growth rate vs. changes in the growth level over

time
Now that the growth rate vs. growth level distinction is clear, let's apply it to the
way that economic policies affect productivity. The most important number in
increasing economic productivity is the growth level. The growth level shows
where the economy is relative to long term positioning. For instance, we know
that the economy tends to grow at about 2% per year in the long run. This is the
economy's growth level. When the economy grows at an increased amount, say
6% per year, the 4% difference between this and the growth level is called the
growth rate.

An economy with a low growth level will not grow very much in the long run even
if the growth rate is high at times. For instance, over a 30-year period, an
economy that has a steady growth level of 3% will far outgrow an economy that
has an unpredictable growth rate but a growth level of 1%. In this way, it is
important to keep both the growth rate and the growth level as high as possible,
but if one is to be preferred over the other, a stable and high growth level is more
desirable than an unpredictably fluctuating growth rate.

Why is this distinction important? Many people are shortsighted. When politicians
manipulate economic variables, they may do so to create desirable short terms
effects or to create desirable long-term effects. If they enact policies that
temporarily increase economic growth, then they are affecting the growth rate. If,
on the other hand, they enact policies that permanently increase economic
growth, then they are affecting the growth level. As long as there is not a tradeoff
between policies that affect the growth level and those that affect the growth rate,
there is no conflict of interest. On the other hand, if increasing economic growth
now results in relatively poorer long term economic growth, politicians may be
tempted to trade an increase in their approval now for a slightly lower economic
growth level. Here is where the difference between growth level and growth rate
is most important, as evaluating economic interventions in the long run is difficult
without employing this differentiation.

Problems
Problem :

What is the only thing that makes an economy grow in the long run?
Solution for Problem 1 >>

Problem :

How do firms produce output?

Solution for Problem 2 >>

Problem :

What types of things make up the general category of capital?

Solution for Problem 3 >>

Problem :

How are the growth level and the growth rate different?

Solution for Problem 4 >>

Problem :

Why is the distinction between growth level and growth rate important?

Solution for Problem 5 >>

Requirements for increased growth

Capital expenditure
In the previous section we learned that increasing capital, both human and
physical, is the only way to create productivity growth in the long run. One way to
directly increase the amount of capital in an economy, also called the capital
stock, is by increasing the spending on capital.

In order to understand how increasing the spending on capital works, it is

necessary to understand how money is spent on capital. In order for most firms
to increase their capital stock, they must purchase additional machinery, tools,
and education for their employees. Because firms do not often have the large
sums of cash necessary for these types of purchases readily available, they must
go to banks to get funding for their capital expenditures. Remember that when
banks make loans, they are simply matching up savers and borrowers. Thus, the
amount of savings by individuals directly affects the amount of money available
for capital expenditures by firms. In this way, the savings rate in a country is the
single most important determinant of the expenditures made by firms on capital.

How much money should be saved in an economy and how much should be
invested in capital? This question is difficult to answer. Some countries, like
Japan, have very high savings rates. Others, like the US, have very low savings
rates. In both cases, the exact effect on the growth of productivity is unclear. In
general, the savings rate that corresponds to the golden rule level of capital is
considered optimal. This is defined as the savings rate that maintains the level of
capital associated with the higher per worker consumption rate. In general, a
savings rate that is as high as possible without significantly reducing the standard
of living of the population is desirable.

Regardless of the savings rate, expenditures on capital directly affect the growth
rate of an economy. They inject the economy with new tools, machinery, and
training. These forms of capital are basic necessities of production. For a given
amount of labor, such an increase in capital will increase possible output.

Technological progress
Of course, spending money to simply increase the amount of capital in an
economy is not the only way to increase productivity. Increases in the quality of
capital can also affect growth. The major way the quality of capital is increased is
through technological progress, the fruit of research and development.
Technological advances can allow a given unit of capital to enable a given unit of
labor to increase production. This increase is contrasted to the increase created
by simply enlarging capital expenditures. In the latter case, a given unit of labor
has more capital to work with and can thus produce more output; while in the
former case a given unit of labor can produce more output with a given unit of
capital.

How does technological progress come about? The major ways are though
innovation and invention. Every year, billions of dollars are spent on research
and development by firms and government agencies, like NASA. This money
leads to improvements in existing technology and to the creation of new
technologies. While innovation and invention may not always be immediately
profitable, in the long run they can prove very lucrative for the researchers and
the developers--as well as for the economy as a whole, as new, more efficient
production technologies become available.

Capital expenditures vs. technological progress

Let's look at a classic example of technological progress. Say that Sam is a

scribe. He spends his days hand copying books and manuscripts. It takes him an
average of 1 day to copy a book. Then the printing press is invented. These new
devices allow books to be issued at a rate of 10 per day. The output is the book.
In this case, an improvement in the technology used to produce output (from quill
pen to printing press) leads to an increase in the output quantity. The invention
and implementation of the printing press thus qualifies as technological progress.

Let's now consider an example of capital expenditures. Say Sam now runs a
printing press and puts out 10 books per day. Then Sam purchases 3 more
printing presses, all of which he can operate simultaneously. Now Sam can use
more of the same technology to increase his daily output to 40 books. Notice
here that output increased, but the quantity--not the quality--of the capital created
this increase. The new upsurge in output is due to an increase in capital
expenditures, and not due to technological progress.

To claim that either increased capital expenditures or increased technological

progress are superior is improper. Instead, each is required for sustained
economic growth. Because technological progress is unpredictable--that is, it is
present and very important at times and not at others--capital expenditures are
able to increase productivity with current capital. When technological progress is
ready to provide new capital for production, then the importance shifts. In this
way, the forces of capital expenditures and technological progress work hand in
hand to increase productivity.
Problems
Problem :

What is the capital stock and how is it increased?

Solution for Problem 1 >>

Problem :

What is the single most important factor in determining the annual increase in the
capital stock?

Solution for Problem 2 >>

Problem :

What is the effect of an increase in the capital stock?

Solution for Problem 3 >>

Problem :

How does technological progress come about?

Solution for Problem 4 >>

Problem :

What is more important for increasing productivity, increased capital

expenditures or increased technological progress?

Solution for Problem 5 >>

Standard of living
Relationship between productivity and unemployment
In the previous section we learned that increases in productivity allow a given
amount of labor to produce a greater amount of output than was possible before
the productivity increase. Popular wisdom dictates that increases in productivity
thus reduce the number of jobs available, because less labor is required to
produce the same amount of output. Fortunately, this is not the case suggested
by the historical economic data. Rather, increased productivity seems to help the
economy overall to a much greater extent than it hurts workers, especially in the
long run.

A historical example will serve to demonstrate this. Since the early 20th century,
there has been an over 1000% increase in output per hour in the US. This means
that, on average, workers today can produce more than 10 times more than what
workers, on average, could produce around the turn of the century. With
productivity increases this high, it seems that unemployment should be very high,
too, as all of the goods and services used in the early 1900's can be produced
now by a much smaller workforce.

But, as productivity increases, so do the number of products and markets

available. Similarly, as products become less expensive, due to more efficient
production methods, the quantity demanded for some of those products also
increases. Overall, in the long run, increases in productivity are offset by
increases in demand, so those jobs are not lost.

Costs of lagging productivity

We just demonstrated how increases in productivity do not necessarily result in a
rise in unemployment. But what is the other side of this coin? That is, what are
the effects of lagging productivity? In general, a country that lags in productivity
will have both lower wages and lower living standards than a country with higher
productivity.

This assumption is based on the idea that all economies trade on the open
market. If a country that lags in productivity produces a good to sell on the
international market, it must price the good at the same level that more
productive countries. In this case, the only way for the lagging country to produce
the good at a low price is to pay labor a low wage. Thus, if labor receives a low
wage, the workers are unable to provide or enjoy a high standard of living.

Let's work this out through an example. Say that there is an international market
for widgets. The going price is $5 per widget. Most productive countries are able
to produce widgets and sell them for this price. One country, which is lagging in
productivity, can only produce widgets at half the speed of the other countries.
But, because the lagging country is only able to sell widgets at $5 each, it must
reduce its costs of production. Since labor is the only cost that can be changed,
as the machines are paid for and their maintenance cannot be put off, workers
are paid less to make the country that lags in productivity competitive in the
international marketplace.

Prosperity
What does a high standard of living entail? This judgement is relatively
subjective, but there are a number of factors that seems to be common to most
economists' ideals. These include physical possessions, nutrition, health care,
and life expectancy. The more prosperous an economy, the better off the citizens
of that economy are in terms of material possessions and health. Thus,
prosperity is attainable when wages are high and countries are highly productive.

This is not to say that prosperity is static. Instead, over time different countries
becomes more and less prosperous. An economic boom in one country may
bring temporary prosperity to that country. Similarly, a depression may wipe out
some hard won gains in prosperity. Overall, prosperity is a relatively subjective
judgement once the basic necessities of life are in place.

GDP per capita

There is a scientific way of measuring prosperity that, while not fully descriptive,
is useful in comparing the standard of living across countries. This is called the
GDP per capita measure. This is simply calculated by dividing the nominal GDP
in a common currency, say US dollars, by the total number of people in the
country. This gives the average amount of income that each member of the
population potentially has access to. In other words, the more money each
individual is able to access the higher the potential standard of living.

This is a useful means of comparing economic wellbeing--that is, prosperity--

across countries. For instance, the GDP per capita in the US is around $25,000
while in Mexico it is around $7000. It stands to reason that by and large, the
standard of living in the US is higher than the standard of living in Mexico. This
same logic can be used to compare the standard of living between any countries.

As mentioned earlier, the GDP per capita measure is the nominal GDP divided
by the population. Thus, for a give amount of output, a country with a smaller
population will have a higher standard of living than a country with a larger
population. This is a problem often encountered in countries with very low GDP
per capita measures of the standard of living. When GDP grows slowly and the
population increases rapidly, the GDP per capita and thus the standard of living
tends to decline over time. Thus, a major way of increasing the standard of living
in a country is to control the population growth rate and thus increase the GDP
per capita.
Problems
Problem : Does increased productivity create unemployment?

Solution for Problem 1 >>

Problem :

What are the effects of lagging productivity?

Solution for Problem 2 >>

Problem :

Why do lags in productivity create both lower wages and lower living standards?

Solution for Problem 3 >>

Problem :

What does a high standard of living entail?

Solution for Problem 4 >>

Problem :
What is GDP per capita and what does it measure?

Solution for Problem 5 >>

Convergence
What is it and why does it happen?
Over time, both productivity and the GDP per capita have increased in
industrialized countries. Interestingly, the productivity and the GDP per capita of
these nations have approached one another over time. This convergence
signifies that all industrialized nations are approaching a common level of
prosperity.

Why does this phenomenon occur? Nobody has a complete answer to this
question. The most common explanation for convergence is the constantly
increasing speed at which new technologies spread across international borders.
Remember that one of the keys to increased productivity is technological
improvement. When industrialized nations share technological advances (rather
than forcing each country to make them independently), productivity for each
country will tend to move towards a level dictated by the performance of modern
production technology.

Does this apply to all countries?

We do not see convergence in all countries. Convergence only occurs among the
industrialized nations. These are countries that have the infrastructure,
government, and education level to utilize the technological advances that can
potentially their production capabilities. Countries that lack a solid infrastructure,
possess an unstable government, or do not possess an educated populace are
unable to benefit from the technological advances that are enjoyed by the
industrialized countries and are thus not covered under the idea of convergence.

This can be illustrated clearly. Say two countries produce widgets. One country
makes widgets by hand at a rate of 1 per day. The other uses advanced
machines to produce widgets at a rate of 100 per day. A technological advance
allows the widget making machine to begin producing 1000 widgets per day.
Unfortunately, only the country that has the widget machine is able to benefit
from this technological advance. The other is still only able to sustain the 1
widget per day level. In this example, the industrialized nations that do converge
are like the mechanized widget producer while the non-industrialized countries
that do not converge are like the non-mechanized widget producer.
Problems
Problem :
What is convergence?

Solution for Problem 1 >>

Problem :

Why does convergence occur?

Solution for Problem 2 >>

Problem :

Does convergence apply to all countries?

Solution for Problem 3 >>

Problem :

What are the necessary conditions for convergence to occur in a country?

Solution for Problem 4 >>

Problem :

Can countries without the conditions necessary for convergence enjoy its
benefits?

Solution for Problem 5 >>

International Trade

Summary
Take a minute and look around. You might be surprised to discover how many of
the everyday items in your life are made overseas. Your shirt might be made in
China. Perhaps your stereo was assembled in Japan. The watch you're wearing
could be from Switzerland. And yes, the shoes that you are sporting might have
been assembled in the United States.

The importing and exporting of goods is big business in today's global economy.
When goods are produced in one country and sold in another, international trade
occurs. It is so common to find items produced worldwide that people rarely even
think about it. Not too long ago, countries consumed goods predominately
produced within their borders. As transportation has become increasingly less
expensive and telecommunications have improved, international trade has
flourished.

In general, international trade allows countries to focus on the industries in which

they can be most productive and efficient. In this way, trade often raises the
standard of living of both producers and consumers. International trade also has
a dark side.

This SparkNote will address many of the questions about international trade that
are probably looming in your mind. Why should countries trade? How does trade
work? What is the effect of international trade? How do exchange rates affect
trade? Can the government interfere in free trade? What is the trade deficit?

The benefits and pitfalls of trade affect the economy at its core. Everything from
output to standard of living to interest rates remains under the partial control of
international trade. By understanding international trade, we will uncover one of
the most important real life applications of macroeconomics.
Terms
Absolute Advantage  -  When a producer can create a given amount of output
with the smallest amount of inputs.
Budget Deficit  -  When the government spends more money than it receives.
Capital  -  Money, machinery, and education put toward a business to increase
its productivity.
Comparative Advantage  -  When a producer has a lower opportunity cost of
production for an item than another producer's.
Consumption  -  Goods and services purchased by consumers.
Cost of living  -  The relative amount of money needed to maintain a given
lifestyle.
Exchange Rates  -  Numbers that tell how much foreign product can be
purchased with similar domestic product.
Exports  -  Goods sent to another country for sale.
Free Trade  -  Trade with which the government does not interfere.
Goods  -  Products that consumers, manufacturers, and governments exchange.
Imports  -  Goods produced in a foreign country and consumed in a domestic
country.
Income  -  Money that enters a country or household.
Investment  -  Money spent to improve a company's growth and productivity.
Net Exports  -  The difference between exports and imports.
Net Foreign Investment  -  The total amount of investment in a country that
results from trade deficits. Net foreign investment always equals net exports.
Nominal Exchange Rates  -  The amount of foreign currency that exchangeable
for domestic currency.
Nominal Output  -  The amount of output valued in currency dollars.
Opportunity Cost  -  What is given up in pursuing one option over another.
Output  -  Goods and services produced.
Protectionist Policies  -  Governmental policies that serve to help developing
domestic industries.
Quota  -  When a government limits the amount of a given good that can be
imported. Imposing quotas is a protectionist policy.
Real Exchange Rates  -  Numbers that describe the relative real value of foreign
and domestic goods.
Subsidy  -  Grants paid by the government to producers to help them develop.
Subsidizing is a protectionist policy.
Tariff  -  Fees charged by the government on imported goods to help raise the
price and decrease the quantity sold. Use of tariffs is a protectionist policy.
Trade  -  When goods from one producer are exchanged for goods from another
producer. In this case, goods can be very broadly interpreted.
Trade Balance  -  Exports minus imports.
Trade Deficit  -  A trade deficit occurs when a country imports more than it
exports.
Trade Surplus  -  A trade surplus occurs when a country exports more than it
imports.
Formulae
 
Output = income Y = C + I +
Y = C + I + G + NX
G + NX
 
Net Exports Net Exports = exports + imports
 
Real exchange rate = ((nominal exchange
Real Exchange Rate
rate)(domestic price)) /(foreign price)
 
Nominal exchange rate = (price of foreign
Nominal Exchange Rate
currency) / (price of domestic currency)

Trade Basics
Why Trade?
Why should countries trade? Simply put, if a country can produce a good for less
than another country, then the opportunity for advantageous trade exists. Of
course, the opportunity for advantageous trade also exists when a country can
produce a good that another country is unable to produce. In each of these
cases, both the consuming country and the producing country will be better off
with trade than without it.

Let's use an example to explain. Say Jim lives on an island with a coconut tree.
Sally lives on another island with a banana tree. Jim tires of eating coconuts and
desires something new to eat. Surprisingly enough, Sally is tired of bananas and
would love some nice sweet coconut. In this example, trade would benefit both
parties.

This example presents only one of the two cases in which trade is adventurous.
In the other case, a country can produce goods at an absolutely or relatively
lower price than another country. These conditions are called the absolute
advantage and the comparative advantage respectively.

Advantages in Trade
A country may have two advantages over another country (or countries)
regarding trade. Absolute advantage occurs when a producer can use the
smallest amount of inputs to produce a given amount of output compared to
other producers. Absolute advantage may apply to many countries. Comparative
advantage happens when a producer has a lower opportunity cost of production
than another producer. Comparative advantage may also apply to many
countries, but in this SparkNote it will be restricted to cases of two countries and
two goods. Each of these two cases will be discussed in detail in the following
paragraphs.

Farmer John has a pistachio farm. It takes him five hours worth of work to
harvest one pound of nuts. Farmer Rick also has a pistachio farm. It takes him
two hours worth of work to harvest one pound of nuts. Farmer Erica owns a third
pistachio farm. She can harvest one pound of nuts in two hours. In this example,
Farmer Erica is said to have the absolute advantage in pistachio production since
she is able to produce the largest amount of output in the smallest amount of
time.

In terms of trade, it is always most beneficial for the producer with the absolute
advantage in the production of a good to specialize in the production of that
good. For instance, in the above example, it was far more productive for Farmer
Erica to spend time harvesting pistachios than it was for Farmer Rick or Farmer
John to do the same. Farmer Erica therefore has a lower cost of production than
either of the other two producers. Applying this idea to international trade leads
us to the conclusion that goods should be produced for which the cost of
production is lowest.

In a more complex model though, producers can produce many different goods.
Often times, if a producer chooses to produce one good, he or she must give up
the opportunity to produce another good. This is called the opportunity cost of
producing a good. The opportunity cost describes what is sacrificed or
relinquished when one choice is taken over another.

Let's use another example. Revisiting the farms belonging to Farmer Erica and
Farmer Rick, we discover that they are both able to produce pistachios and
soybeans. Farmer Erica can harvest 1 pound of pistachios in 2 hours and she
can harvest 5 pounds of soybeans in 2 hours. Farmer Rick, on the other hand,
can harvest 1 pound of pistachios in 10 hours and 50 pounds of soybeans in 2
hours.

Looking at this information in terms of the total amount of time each farmer takes
to harvest a pound of each product is the next step to understanding comparative
advantage. Farmer Erica can harvest 1 pound of pistachios in an hour while it
takes Farmer Rick 10 hours to harvest 1 pound of pistachios. On the other hand,
Farmer Rick can harvest 1 pound of soybeans in about 2.5 minutes, but it takes
Farmer Erica about 24 minutes to harvest a pound of soybeans.

Since each of these farmers only has a fixed number of hours to spend
harvesting, each hour spent harvesting pistachios cannot be spent harvesting
soybeans, and similarly, each hour spent harvesting soybeans cannot be spent
harvesting pistachios. For every hour Farmer Erica spends picking soybeans,
she gives up 0.5 pounds of pistachios; and for every hour that Farmer Erica
spends picking pistachios, she gives up 0.1 pounds of soybeans. Farmer Rick
gives up 25 pounds of soybeans for every hour that he spends harvesting
pistachios, and for every hour that Farmer Rick spends harvesting soybeans, he
gives up 0.1 pounds of pistachios.

We can reexamine this example in terms of opportunity costs. Farmer Erica has
an opportunity cost of 0.1 pounds of soybeans for every 0.5 pounds of pistachios
harvested, or similarly, 5 pounds of pistachios for every 1 pound of soybeans
harvested. Farmer Rick has an opportunity cost of 0.1 pounds of pistachios for
every 25 pounds of soybeans harvested, or 250 pounds of soybeans for every
pound of pistachios harvested.

Figure %: Opportunity costs of production

Figure 1 depicts the situation described above. Notice that for Farmer Erica, the
opportunity cost of harvesting pistachios is lower than the opportunity cost of
harvesting soybeans. Similarly, for Farmer Rick, the opportunity cost of
harvesting soybeans is lower than the opportunity cost of harvesting pistachios.
In both of these cases, this means that both farmers are better off spending their
time harvesting the product that they can produce most efficiently.

The producer with the lower opportunity cost of production is said to have the
comparative advantage. Notice that in a case with two producers and two
products, each producer must have a comparative advantage in one, and not
both, products. Figure 1 makes finding the comparative advantage easy. Simply
represent the opportunity cost of one product in terms of the other product for
both producers, and then compare these numbers. Whichever producer has the
lower opportunity cost has the comparative advantage and should produce that
product.

Absolute advantage and comparative advantage are theoretically straightforward.

When a producer has an absolute advantage, he can produce a given output by
using fewer inputs than any competing producer. When a producer has a
competitive advantage, he can produce one product with a smaller amount of
inputs than the competition. He therefore must produce another product with a
greater amount of inputs than the competitor, hence the designation of
comparative advantage. When either an absolute advantage or a comparative
advantage exists, benefits from trade are guaranteed.
Problems
Problem : Why should countries trade?

Solution for Problem 1 >>

Problem : Explain absolute advantage.

Solution for Problem 2 >>

Problem : Explain comparative advantage.

Solution for Problem 3 >>

Problem : Who should produce goods when using trade advantages as criteria?

Solution for Problem 4 >>

Problem : What is an opportunity cost?

Solution for Problem 5 >>

The Means of Trade

Flows of Capital and Goods
In the first macroeconomics SparkNote on measuring the economy, we learned
the identity Y = C + I + G + NX to describe the output of an economy. In this
equation, Y is the nominal output, C is money spent on consumption, I is money
spent on investment, G is money spent by the government, and NX is net exports
or exports less imports. The sum of these costs is the total amount of both
income and output in a country.

To understand how capital and goods flow in and out of countries, we should
keep the Y = C + I + G + NX identity in mind. NX is of particular interest. NX is
defined as the total amount of exports less the total amount of imports. NX is
positive if a country exports more than it imports, negative if a country imports
more than it exports, and zero if exports and imports are equal.

Let's work through each of these examples in turn. First we'll examine the
simplest case, in which exports and imports are equal. In this example, there are
two countries, Country A and Country B. If Country A exports 1 million dollars
worth of coconuts to Country B and imports 1 million dollars worth of bananas
from Country B, then the NX for both countries is equal to zero since exports
equal imports. In this case, goods are traded for goods and at the end of the
term, the trade balance is equal.

When countries import less than they export or import more than they export, the
situation becomes significantly more complicated. Now let's examine the case
when a country imports more than it exports. If Country A exports 0.5 million
dollars worth of coconuts to Country B and imports 1 million dollars worth of
bananas from Country B, then Country A has a negative trade balance, called a
trade deficit. In this case, Country A owes Country B money for the imported
bananas beyond the 0.5 million dollars worth of exported coconuts. If this is a
short-term debt, nothing of consequence would occur since Country A has the
ability to export more coconuts quickly to make up for the difference.
If the debt is long term, however, Country A must somehow repay Country B for
the imported bananas. The easiest way to think of this exchange is to imagine
Country A giving Country B interest in the future coconuts produced by Country
A. To repay the debt that Country A owes to Country B, Country B becomes
invested in Country A. Any amount of exports that exceeds the total amount of
imports results in foreign investment. The opposite occurs when exports exceed
imports as the exporting country becomes a foreign investor in the importing
country.

This leads us to another important international trade identity: NX = NFI where

NX is net exports or exports less imports and NFI is net foreign investment.
Simply put, the difference between what a country exports and imports is equal
to the amount of foreign investment. The trade balance can remain fairly even if a
country imports more than it exports--it must make up the difference through
foreign investment.

If net exports remain equal to net foreign investment, a few tendencies arise:

15. countries with few imports and many exports will tend to have significant
foreign investment
16. countries with few exports and many imports will also tend to have
significant foreign investment
17. countries with exports equal to imports will tend to have little investment in
foreign countries and little foreign investment
Understanding the identity NX = NFI and the means by which capital and goods
flow between countries helps to clarify the workings of international trade.
Problems
Problem : What identity describes both output and income?

Solution for Problem 1 >>

Problem : How do we calculate net exports?

Solution for Problem 2 >>

Problem : If a country exports $200 worth of goods and imports $300 worth of
goods, what is the level of net exports?

Solution for Problem 3 >>

Problem : What happens when net exports are negative?

Solution for Problem 4 >>

Problem : Would you expect a country that has few imports and many exports to
have much foreign investment?

Solution for Problem 5 >>

Exchange Rates
Nominal Exchange Rates versus Real Exchange Rates
As we begin discussing exchange rates, we must make the same distinction that
we made when discussing GDP. Namely, how do nominal exchange rates and
real exchange rates differ?

The nominal exchange rate is the rate at which currency can be exchanged. If
the nominal exchange rate between the dollar and the lira is 1600, then one
dollar will purchase 1600 lira. Exchange rates are always represented in terms of
the amount of foreign currency that can be purchased for one unit of domestic
currency. Thus, we determine the nominal exchange rate by identifying the
amount of foreign currency that can be purchased for one unit of domestic
currency.

The real exchange rate is a bit more complicated than the nominal exchange
rate. While the nominal exchange rate tells how much foreign currency can be
exchanged for a unit of domestic currency, the real exchange rate tells how much
the goods and services in the domestic country can be exchanged for the goods
and services in a foreign country. The real exchange rate is represented by the
following equation: real exchange rate = (nominal exchange rate X domestic
price) / (foreign price).

Let's say that we want to determine the real exchange rate for wine between the
US and Italy. We know that the nominal exchange rate between these countries
is 1600 lira per dollar. We also know that the price of wine in Italy is 3000 lira and
the price of wine in the US is $6. Remember that we are attempting to compare
equivalent types of wine in this example. In this case, we begin with the equation
for the real exchange rate of real exchange rate = (nominal exchange rate X
domestic price) / (foreign price). Substituting in the numbers from above gives
real exchange rate = (1600 X $6) / 3000 lira = 3.2 bottles of Italian wine per bottle
of American wine.

By using both the nominal exchange rate and the real exchange rate, we can
deduce important information about the relative cost of living in two countries.
While a high nominal exchange rate may create the false impression that a unit
of domestic currency will be able to purchase many foreign goods, in reality, only
a high real exchange rate justifies this assumption.

Net Exports and the Real Exchange Rate

An important relationship exists between net exports and the real exchange rate
within a country. When the real exchange rate is high, the relative price of goods
at home is higher than the relative price of goods abroad. In this case, import is
likely because foreign goods are cheaper, in real terms, than domestic goods.
Thus, when the real exchange rate is high, net exports decrease as imports rise.
Alternatively, when the real exchange rate is low, net exports increase as exports
rise. This relationship helps to show the effects of changes in the real exchange
rate.
Problems
Problem : How do we calculate the nominal exchange rate?

Solution for Problem 1 >>

Problem : How do we calculate the real exchange rate?

Solution for Problem 2 >>

Problem : How do the nominal exchange rate and the real exchange rate differ?

Solution for Problem 3 >>

Problem : How do net exports relate to the real exchange rate?

Solution for Problem 4 >>

Problem : If a country has a high real exchange rate, what does this tell you
about the nominal exchange rate?

Solution for Problem 5 >>

Trade and the Country

Barriers to Trade
It may seem odd, but governments often step in to restrict trade. Why might a
government want to restrict trade? If domestic industries cannot compete against
foreign industries, the government will restrict trade to help the domestic
industries develop. Governments may also restrict trade to foster business at
home rather than encouraging business to move out of the country. These
protectionist policies encourage prices to stay high and help domestic industries
to develop.

Trade Interferences

Governments three primary means to restrict trade: quota systems; tariffs; and
subsidies.

A quota system imposes restrictions on the specific number of goods imported

into a country. Quota systems allow governments to control the quantity of
imports to help protect domestic industries.

Tariffs are fees paid on imported goods. Tariffs increase the price that
consumers pay for the good, thus reducing the quantity of the good demanded
and making the price more in line with the price charged by domestic producers.
Tariff profits may go to the government or to developing industries.

Subsidies are grants given to domestic industries to help them develop and
compete with foreign producers. Through subsidies, domestic producers can
charge less for their goods without losing money due to outside grants.

Through judicious use of quotas, tariffs, and subsidies, governments are able to
improve the domestic economy. This may increase the price that domestic
consumers pay for goods, though this small annoyance is usually outweighed by
significantly bolstered overall economic levels and long-term economic growth.

Trade Deficit

In the section on net exports we learned that net exports equal exports minus
imports. The difference between exports and imports is referred to as the trade
deficit or the trade surplus. When exports exceed imports, a trade surplus exists.
When imports exceed exports, a trade deficit exists.

There often talk about the effects of the trade deficit on the economy. What is the
actual effect of the trade deficit though? Remember that when there is a trade
deficit, net foreign investment fills the gap between exports and imports, as NX =
NFI. Thus, if a large trade deficit exists, foreign investment must be high. This is
slightly problematic as domestic companies often enjoy domestic ownership--a
large trade deficit threatens this condition. A trade deficit is often matched with a
large governmental budget deficit. Though the specific effects of a trade deficit
are nebulous, in general a large trade deficit is thought to stunt long-term
economic growth slightly.

How can the trade deficit be resolved? First, exports can be increased to make
annual net exports positive. When employed, this method will cause a trade
deficit decrease over time. Second, funds can be used to pay off foreign
investors, reducing balance due from trade and causing a lower trade deficit.

Problems
Problem : Why would a government impede free trade?

Solution for Problem 1 >>

Problem : How do quotas work?

Solution for Problem 2 >>

Problem : How do tariffs work?

Solution for Problem 3 >>

Problem : How do subsidies work?

Solution for Problem 4 >>

Problem : What are two harmful effects of a large trade deficit?

Solution for Problem 5 >>