Lecture 5 Basics of Macroeconomics II Dr Rajeev

Lecture 5: Basics of Macroeconomics II Dr. Rajeev Dhawan Director Given to the EMBA 8400 Class April 16, 2010

Chapter 28 Unemployment & Its Natural Rate

U. S. Unemployment, 1960 -2007 percentage of labor force 12 10 Unemployment rate 8 6 4 Natural rate of unemployment 2 0 1965 1970 1975 1980 1985 1990 1995 2000 2005

Identifying Unemployment ¨ Natural Rate of Unemployment – The natural rate of unemployment is unemployment that does not go away on its own even in the long run. – It is the amount of unemployment that the economy normally experiences. ¨ Cyclical Unemployment – Cyclical unemployment refers to the year-to-year fluctuations in unemployment around its natural rate. – It is associated with short-term ups and downs of the business cycle.

How Is Unemployment Measured? ¨ Based on the answers to the survey questions, the Bureau of Labor Statistics (BLS) places each adult into one of three categories: – Employed – Unemployed – Not in the labor force ¨ Labor Force – The labor force is the total number of workers, including both the employed and the unemployed. – The BLS defines the labor force as the sum of the employed and the unemployed.

Breakdown Of The Population In 2007 Employed (146. 0 million) Adult Population (231. 8 million) Unemployed (7. 1 million) Not in labor force (76. 0 million) Labor Force (153. 1 million)

Unemployment - What is it? ¨ The unemployment rate is calculated as the percentage of the labor force that is unemployed. ¨ Labor Force Participation Rate

Example ¨ In 2001, 135. 1 million people were employed and 6. 7 million people were unemployed. – Labor Force = 135. 1 + 6. 7 = 141. 8 million – Unemployment Rate = (6. 7 / 141. 8) X 100 = 4. 7 percent – Labor Force Participation Rate = (141. 8 / 211. 9) X 100 = 66. 9 percent

Figure 3 Labor Force Participation Rates for Men and Women Since 1950 Labor-Force Rate (in percent) Men Women

The Labor-Market Experiences of Various Demographic Groups (2007) Demographic Group Adults (ages 20 and older) White, male White, female Black, female Teenagers (ages 16– 19) White, male White, female Black, female Unemployment Rate Labor-force Participation Rate 3. 7% 3. 6 7. 9 6. 7 76. 3% 60. 1 71. 2 64. 0 15. 7 12. 1 33. 8 25. 3 44. 6 29. 4 31. 2 This table shows the unemployment rate and the labor-force participation rate of various groups in the U. S. population for 2007 Copyright© 2004 South-Western

Questions About Unemployment ¨ Does the Unemployment Rate Measure What We Want It To? ¨ How Long Are the Unemployed without Work? ¨ Why Are There Always Some People Unemployed?

Article: Why do Americans Work More Than Europeans? WSJ; by: Edward Prescott ¨ Americans aged 15 -64, on a per-person basis, work 50% more than French. The French, for example, prefer leisure more than do Americans or on the other side of the coin, that Americans like to work more. This is silliness !! ¨ Germans and Americans spend the same amount time working, but the proportion of taxable market time vs. nontaxable home work time is different ¨ But marginal tax rates explain virtually all of this difference. Labor supply is not fixed. People be they European or American, respond to taxed on their income. – Spanish labor supply increased by 12% in 1988 when taxes were cut

Chapter 29 The Monetary System

Money–What is it and what does it do? Money is the set of assets in an economy that people regularly use to buy goods and services from one another ¨ Medium of Exchange –what sellers accept from buyers as payment for goods and services. Eliminates inefficiencies of barter. ¨ Unit of Account – When there is one unit of account, like the ($) in the United States, you don't have to think in relative terms when valuing goods and services. ¨ Store of Value – people have the option to hold money over time as one way of storing their assets. Money is an important store of value, because it is the most liquid asset in the economy

Types of Money ¨ Commodity Money money that takes the form of a commodity with intrinsic value. ¨ Fiat Money money without intrinsic value that is used as money because of government decree

How to Measure Money Stock: The quantity of money circulating in the economy Q: Suppose you want to know the size of the U. S. money stock. What should you count as money? A: Currency and demand deposits, and a few other items (detailed below) but not credit cards. Currency - the paper bills and coins in the hands of the public Demand Deposits - balances in bank accounts that depositors can access on demand by writing a check (or by using a debit card)

Two Measures of the Money Stock for the U. S. Economy (2007) Billions of Dollars M 2 $7, 447 • Savings deposits • Small time deposits • Money market mutual funds • A few minor categories ($6, 083 billion) $1, 363 0 M 1 • Demand deposits • Traveler’s checks • Other checkable deposits ($605 billion) • Currency ($759 billion) • Everything in M 1 ($1, 364 billion)

Continued… Q: How is the U. S. money stock measured and reported? A: Two most important measures – M 1 and M 2 M 1 = Currency, Traveler's checks, Demand Deposits and Other Checkable Deposits Here is a breakdown of M 1 for 1996: Item$ (Billions) % of total Currency Traveler's Checks Demand Deposits Other Checkable Deposits $1076. 8 100. 0% 395. 7 36. 7 8. 6 0. 8 400. 7 37. 2 271. 8 25. 3 M 2 = Everything in M 1 plus Savings deposits, Small Time Deposits, Money Market Mutual Funds and a few minor categories. M 2 for 1996 was $3657. 4 billion.

Banks & Money Supply Q: How do banks operate? A: Banks accept deposits from people. That money is in an account until the depositor makes a withdrawal or writes a check on their account. Q: Do banks keep all of your money in their vault? A: No. Our banking system is called fractional reserve banking. Bankers understand that it is not necessary to keep 100 percent of a depositors money on hand at all times. As a result, bankers take some of your money and loan it out to other people.

Continued. . ¨ Fractional reserve banking - a banking system in which banks hold only a fraction of deposits as reserves ¨ Reserve ratio - the fraction of deposits that banks hold as reserves. Minimum reserve ratios are set by the Fed.

Money Creation with Fractional-Reserve Banking ¨ When a bank makes a loan from its reserves, the money supply increases. ¨ The money supply is affected by the amount deposited in banks and the amount that banks loan. – Deposits into a bank are recorded as both assets and liabilities. – The fraction of total deposits that a bank has to keep as reserves is called the reserve ratio. – Loans become an asset to the bank.

Money Creation with Fractional. Reserve Banking ¨ This T-Account shows a bank that… – accepts deposits, – keeps a portion as reserves, – and lends out the rest. – It assumes a reserve ratio of 10%. First National Bank Assets Reserves $10. 00 Liabilities Deposits $100. 00 Loans $90. 00 Total Assets $100. 00 Total Liabilities $100. 00

Money Creation with Fractional-Reserve Banking ¨ When one bank loans money, that money is generally deposited into another bank. ¨ This creates more deposits and more reserves to be lent out. ¨ When a bank makes a loan from its reserves, the money supply increases.

The Money Multiplier First National Bank Assets Reserves $10. 00 Liabilities Deposits $100. 00 Loans $90. 00 Total Assets Total Liabilities $100. 00 Second National Bank Assets Reserves $9. 00 Liabilities Deposits $90. 00 Loans $81. 00 Total Assets $90. 00 Money Supply = $190. 00! Total Liabilities $90. 00

The Money Multiplier Suppose that the Fed requires banks to keep 10 percent of their demand deposits on reserve. Q: What happens when somebody brings in $100 and deposits it in a bank? A: The bank is required to keep $10 (10 percent) on reserve. Q: What does the bank do with the remaining $90? A: The bank will turn around and lend it to somebody else, earning interest income for the bank. Q: What did that $90 loan do to the size of the money supply? A: The money supply increased by $90 when the loan was made. Why? When the bank made the $90 loan, $90 in currency reentered the money supply

Continued… ¨ Now suppose that the person who received the $90 loan deposits that money into their checking account. ¨ Q: What does the bank have to do with the $90? ¨ A: Keep 10 percent on reserve (10 percent of $90 = $9). ¨ ¨ Q: What does the second bank do with the remaining $81? ¨ A: They can lend that out to somebody else

Money Multiplier Q: How far does this process of money creation go? A: The process of bank money creation continues until there are no more excess reserves to be lent out. Money multiplier - the amount of money the banking system generates with each dollar of reserves. The money multiplier is the reciprocal of the reserve ratio: M = 1/R With a reserve requirement, R = 10% or 1/10, The multiplier is 5. Therefore, the original $100 deposit will eventually turn into $1000 of deposits. Q: The banking system can create money, but can it also create real wealth? A: No. Each loan has two parts. Recall that the first $90 loan generated $90 in new money. At the same time, that $90 loan also created a new $90 liability for the person borrowing the money. The banking system cannot create real wealth.

The Federal Reserve System ¨ The Federal Reserve (Fed) serves as the nation’s central bank. – It is designed to oversee the banking system. – It regulates the quantity of money in the economy. ¨ The primary elements in the Federal Reserve System: 1) The Board of Governors 2) The Regional Federal Reserve Banks 3) The Federal Open Market Committee

The Federal Reserve System Copyright© 2003 Southwestern/Thomson Learning

The Fed’s Organization ¨The Federal Open Market Committee (FOMC) – Serves as the main policy-making organ of the Federal Reserve System. – Meets approximately every six weeks to review the economy.

The Fed’s Tools of Monetary Control ¨ The Fed has three tools in its monetary toolbox: – – – Open-market operations Changing the reserve requirement Changing the discount rate NEW ALPHABET SOUP OF CREDIT PROGRAMS BUYING T-BONDS & MBS/DEBT

The Fed’s Tools of Monetary Control Open-Market Operations – The Fed conducts open-market operations when it buys government bonds from or sells government bonds to the public: – When the Fed buys bonds, the money supply is increased. Here is why: The Fed pays for the bonds it buys with money that was not currently a part of the money supply, hence, when the Fed buys bonds it simply increases the total amount of money in circulation. – When the Fed sells bonds, the money supply is decreased. Here is why: The Fed sells bonds in the market and receives cash in return for the bonds it sells. Once the Fed receives the cash, this cash is taken out of circulation – therefore, the size of the money supply is decreased.

The Fed’s Tools of Monetary Control ¨ Reserve Requirements – The Fed also influences the money supply with reserve requirements. – Reserve requirements are regulations on the minimum amount of reserves that banks must hold against deposits.

Problems in Controlling the Money Supply ¨ The Fed must wrestle with two problems that arise due to fractional-reserve banking. – The Fed does not control the amount of money that households choose to hold as deposits in banks. – The Fed does not control the amount of money that bankers choose to lend.

Credit Crunch Update

Up 60% Down 50%

Chapter 30 Money Growth and Inflation

The Classical Theory of Inflation ¨ Inflation is an increase in the overall level of prices. Inflation erodes purchasing power of money. ¨ Hyperinflation is an extraordinarily high rate of inflation. ¨ Historical Aspects – Over the past 60 years, prices have risen on average about 5 percent per year. – In the 1970 s prices rose by 7 percent per year. – During the 1990 s, prices rose at an average rate of 2 percent per year. – Deflation, meaning decreasing average prices, occurred in the U. S. in the nineteenth century. – Hyperinflation refers to high rates of inflation such as Germany experienced in the 1920 s.

Money Supply, Money Demand Monetary Equilibrium ¨ The money supply is a policy variable that is controlled by the Fed. – Through instruments such as open-market operations, the Fed directly controls the quantity of money supplied. ¨ Money demand has several determinants, including interest rates and the average level of prices in the economy. ¨ People hold money because it is the medium of exchange. – The amount of money people choose to hold depends on the prices of goods and services. ¨ In the long run, the overall level of prices adjusts to the level at which the demand for money equals the supply.

Money Supply, Money Demand, and the Equilibrium Price Level Value of Money, 1/P (High) Price Level, P Money supply 1 1 (Low) 3 1. 33 /4 / 12 Equilibrium value of money (Low) A 2 Equilibrium price level 4 / 14 Money demand (High) 0 Quantity fixed by the Fed Quantity of Money Copyright © 2004 South-Western

Figure 2 The Effects of Monetary Injection Value of Money, 1/P (High) MS 1 MS 2 1 (Low) 1 1. An increase in the money supply. . . 3 2. . decreases the value of money. . . Price Level, P /4 12 / 1. 33 A 2 B / 14 3. . and increases the price level. 4 Money demand (High) (Low) 0 M 1 M 2 Quantity of Money Copyright © 2004 South-Western

The Classical Theory of Inflation ¨ The Quantity Theory of Money – How the price level is determined and why it might change over time is called the quantity theory of money. ¨The quantity of money available in the economy determines the value of money. ¨The primary cause of inflation is the growth in the quantity of money.

Velocity and the Quantity Equation ¨ The velocity of money refers to the speed at which the typical dollar bill travels around the economy from wallet to wallet. V = (P Y)/M Where: V = velocity P = the price level Y = the quantity of output M = the quantity of money ¨ Rewriting the equation gives the quantity equation: M V=P Y

Velocity & Quantity Equation ¨ Velocity ( V ) = Nominal GDP/ Money Supply = ( P x Y ) / M ¨ Example: V = ($10 x 100 ) / $ 50 = 20

Velocity & Quantity Equation ¨ The quantity equation relates the quantity of money (M) to the nominal value of output (P Y). ¨ The quantity equation shows that an increase in the quantity of money in an economy must be reflected in one of three other variables: – the price level must rise, – the quantity of output must rise, or – the velocity of money must fall.

Velocity and the Quantity Equation ¨ The Equilibrium Price Level, Inflation Rate, and the Quantity Theory of Money – The velocity of money is relatively stable over time. – When the Fed changes the quantity of money, it causes proportionate changes in the nominal value of output (P Y). – Because money is neutral, money does not affect output.

Nominal GDP, the Quantity of Money, and the Velocity of Money

The Inflation Tax ¨ When the government raises revenue by printing money, it is said to levy an inflation tax. ¨ An inflation tax is like a tax on everyone who holds money. ¨ The Fisher effect refers to a one-to-one adjustment of the nominal interest rate to the inflation rate.

The Nominal Interest Rate and the Inflation Rate

Costs of Inflation 1. 2. 3. 4. Shoeleather Costs – resources wasted when inflation encourages people to reduce their holdings of money. Menu Costs – the costs involved in actually changing prices around the economy. Relative Price Variability and the Misallocation of Resources – If firms only occasionally change their prices (like once per year), then they have to guess at the future level of inflation. Their prices will be too high early in the year and too low late in the year, resulting in sales that are artificially low early in the year and artificially high late in the year. Inflation-Induced Tax Distortions – Taxes like capital gains and interest income taxes are imposed on the nominal value of assets or on interest income. From studying real versus nominal interest rates, you know that part of the nominal interest rate exists to compensate people for the effects of inflation. The higher is the rate of inflation, the higher is this distortion caused by these taxes.

Continued. . 5. Confusion and Inconvenience – Money, being the economy's unit of account, is used to quote prices for goods and services throughout the economy. Confusion and inconvenience arise as a cost of inflation because inflation makes valuing dollars over time difficult. Many important items in the economy are measured over time (like the value of a firm, for instance), and inflation creates difficulties in the valuation of assets or debts that occur over time. 6. Arbitrary Redistributions of Wealth – "Inflation is good for borrowers and bad for lenders" is a common phrase that rings out in economics principles courses. Here's a personal example for you to consider (and a personal example for your website author as well). When you graduate from college, you will likely owe money on student loans that you took out during your college years. Between the time you borrowed the money and the time when you repay the loan, you will be better off if inflation is high.

Overhang of Toxic Debt

Bad Luck for Streets of Buckhead As of the 4 th quarter, about 20% of $440 billion of construction loans outstanding were more than 30 days past due, compared to 11. 4% a year ago. Banks will have their hands full in the coming months. About $566 billion is commercial real estate debt, the majority of which was provided by banks, comes due in 2010 and 2011. (Foresight Analytics) Source: The Wall Street Journal, January 22, 2010

Atlanta’s Irrational Building Update Two Alliance Center Planned Opening: June 2009 Occupancy Rate: 31% Financial Situation: project amount $116 million Terminus 200 Planned Opening: Aug 2009 Occupancy Rate: 8. 8% Financial situation: took a $39 mm write-down 3630 Peachtree Planned Opening: Aug 2009 Occupancy Rate: no leasing deal reported Financial Situation: took a $50 mm write-down Phipps Tower Planned Opening: March 2010 Occupancy Rate: No leasing deal reported Financial Situation: project amount $95 million Source: The Wall Street Journal, April 22, 2009

Atlanta’s Office and Industrial Vacancy Source: Atlanta Office Market Analysis for 2009 Q 4. Cushman & Wakefield

S&Ls Crisis

Meanwhile, in the Early 90’s…

Households Labor Large Firms Labor Financial Institution Goods Small Firms

Figure 1: Return Function of the Intermediary p* l pl(L) K* K

MPL ( high capital) > MPL (low capital)

Fear of Fire Sales and the Credit Freeze Douglas Diamond Professor of Finance University of Chicago Raghuram Rajan Professor of Finance University of Chicago “overhang” of impaired banks …an that may be forced to sell soon can reduce the current price of illiquid securities sufficiently that banks have no interest in selling. This creates high expected returns to holding cash for potential buyers and an aversion to making term loans. Source: NBER working paper #14925, April 2009

Cease & Desist Orders in Georgia Institution 2007 2008 2009 FDIC 1 13 49 NCUA 2 0 1 OTS 1 0 3 CCANB 1 2 5 5 15 58 Total All Institutions As of December 31 th 2009, there were 309 banks in Georgia. FDIC NCUA OTS CCANB = Federal Insurance Deposit Corporation = National Credit Union Administration = Office of Thrift Supervision = Comptroller of the Source: Currency Administrator of National Banks Georgia Bankers Association and each institution’s website.

Aerospace Bust Led to a Real Estate & Jobs Bust in Early 90 s Real Estate Recovery was Led by Hispanic Buyers; Hollywood Fills in the jobs Vacuum somewhat

Beverly Hills South Central L. A. Source: UCLA Business Forecasting Project Report, September 1996

Article: Haute Con Job (PIMCO) aka Bill Gross’s Beef With Inflation Methodology Ø Bill Claims that Hedonic Pricing a. k. a. Haute Con Job is Keeping Inflation Rate Low Ø Low Inflation => Higher Productivity (Calculations) Ø => FED Can Keep Rates Low, Keep the Consumption Boom, and Greenspan His Legacy! Ø Government Can Keep Social Security Payments Down Ø It Hurts Investors, Especially His TIPS Holders Ø Bill Says Core Inflation is Not the Real Metric of Measuring the Cost of Living as We Still Have to Pay for Food & Energy in Real Life!

Article: Con Job Redux (PIMCO) by: Bill Gross Ø Bill claims that CPI inaccurately calculates Americans’ cost of living. Ø Example: Say you buy 1 bag of gumdrops for $1 which has 100 of those. Productivity makes it 110 gumdrops but for $1. 10. Hedonic pricing says that CPI hasn’t gone up as per-capita cost is the same (1 cent). But you have to shelve out $1. 10 to get the bag, which is an increase in cost of 10%. They must fork out an extra dime even though they’re getting more for their money. Ø We can’t buy individual pieces of memory in a computer-we have to buy the entire package!