2.MACROECONOMICS

SECTION 1 - CHAPTER 2MACROECONOMICSI FEDERAL STATUTORY CONSTRAINTS ...............................................................................................A. Regulatory Agencies ..........................................................................................................................................B. Anti-Trust Legislation ......................................................................................................................... ................. II. FISCAL POLICY ..................................................................................................................................A. GNP and the Circular Economic Model ........................................................................................... ............B. Consumption, Savings and Investment Analysis ...............................................................................................C Multiplier Effect .................................................................................................................................................D. Economic Cycles .............................................................................................................................................E. Employment and Unemployment ....................................................................................................... ..........F. Inflation ...........................................................................................................................................................G. Political Considerations...................................................................................................................... ................H. The Deficit and Its Implications......................................................................................................... ................I. Taxation Methods and Theories ..................................................................................................................... III. MONETARY POLICY……………………………………………………………………………..A. Uses and Measurement of Currency ...................................................................................................................B. Money and Interest Rate Determinants ..............................................................................................................C. Equation of Exchange ........................................................................................................................................D. Federal Reserve System .....................................................................................................................................E. Effectiveness of Monetary Policy ......................................................................................................................F.Interest Rates Relationship ..................................................................................................................................G.Interest Rate Friction ......................................................................................................................................... IV. MACROECONOMIC CONTROVERSIES ......................................................................................A. Keynesian Theory .......................................................................................................................................B. Monetarists' Theory ....................................................................................................................................C. Neo-Keynesian Theory .................................................................................................................................D. Supply-Side Theory ......................................................................................................................... .............SECTION 1 - CHAPTER 2MACROECONOMICSI.FEDERAL STATUTORY CONSTRAINTSA. In General1. Public Awareness:Higher age longevity and heightened social awareness in the 1970s resulted as well as the American public’s seeking for an improved quality of life emphasizi ng the issues of health, pollution and consumer-oriented safety legislation. A greater awareness of the scarcity of precious depletable natural resources is also developed.2. Imperfections in Market and Externalities: Since there is an increase in media coverage of the few imperfections in the market system, caused a general disenchantment with a system that seemed geared to make a profit at the expense of others took place. A public mistrust for big business developed, and there was a sense that legislation was necessary to protect the rights of individuals in the workplace. The negative environmental impact of technology and industry resulted in increased public concern. The sense was that the cost of the externality effect on third parties or the public should be borne by the wrong-doer and not society as a whole.3.Media Coverage of Social Issues:Eventually, increased media coverage of social issues led to increased public awareness. Overall, these factors were responsible for resulting in the largest increase in new legislation and administrative agencies in the country’s history.B. Regulatory Agencies1. Creation:Government regulations show both statutory and regulatory in nature. A federal statute needs both the Senate and House to pass the measure and the President to seal signature on the Act. The Executive has veto power, but Congress can override the veto. The statute may generate the formation of an administrative agency or commission to implement the Congressional mandate. The regulatory agency itself may have enforcement powers and usually an internal system to resolve disputes. The agency does not usually impose agency taxes on private industry. Federal agencies may be for specific industrial development (Civil Aeronautics Board) or specific purposes for administrative (Environmental Protection Agency).2. Administrative Law: Citizens have substantive and procedural rights designed to guarantee fairness in agency actions and to offer a judicial remedy for arbitrary and capricious decisions. The rules and regulations which govern their own procedures and enforcement procedures must be published. Agency regulations must be consistent with the standards established in the congressional act which formulated the agency.3. Judicial Review: Judicial appeal is only possible if the appellant has standing due to a personal stake in the outcome of the case, the case is ripe with immediate injury, and all internal agency administrative remedies have been exhausted.a. Determinations of Fact: With the support of substantial evidence, agency determinations of fact are usually upheld.b. Determinations of Law: Agency determinations of law are under the manipulation of a high degree of scrutiny and are more susceptible to reversal than are matters of fact. Very often, it involves a condition where the agency has extended authority scope beyond the authorized statute.c.Application of Law to Fact: Agency conclusions as to a law application of law to a particular factual setting are usually upheld. A court reversal needs concrete indication of an abuse of discretion, capricious as well as/or arbitrary decision from the agency.4. Agency Regulatory Decisions:Regulatory agencies may determine decisions made by the free market in normal circumstances.a. Public Interest: Wherever there is a high public interest, such as public or common-pool resources, regulation may be justified. Frequently, there is application of regulation to industries that have an inelasticdemand curve, natural monopolies, as well as other necessary services such as electricity, the phone company as well as city transportation systems. Only one supplier can be in business. Collusion among firms in an oligopoly industry can also create free-market failures. Firms with substantial vertical or horizontal integration may counteract against the public interest.b.Three Purposes of Regulation:(i)To ensure the availability of service to all customers,(ii)To establish standards for the minimum quality and safety of the service,(iii)To guarantee that the public will be charged reasonable prices.c. Price and Supply: The Agency, through rate hearings, usually determines the price the market will pay. The established rates set by the Agency must cover operating costs plus a fair and equitable rate of return on invested capital.d. Disadvantages:(i)Critics of regulation argue that such agencies decrease consumer freedom.(ii)Regulated industries may be exempted from the antitrust laws by statute or court decisions.(iii)Some allege that regulators tend to be captive of the industry they regulate.(iv)Business firms involved in dealing with regulatory agencies do not usually receive compensation for their (often required) time and effort.(v)Regulators may have more in common with the regulated companies than the public they supposedly represent.(vi)Agency personnel are often recruited from an industry firm and often join the industry when they leave the agency.5. Sunset Legislation: To cope with the ever-increasing legislation explosion, elected officials may enact sunset laws. This has the effect of terminating the effect of a legislative enactment (plus any related administrative agency) as of a specific date. Sunset laws are a type of deregulation6. Deregulation: Patent laws, price supports and price ceilings all discourage perfect competition. Radio and television broadcasting, telecommunications, stock brokerage, airlines, railroads, and banking are all potentially competitive industries which have been subjected to regulation. Advocates of deregulation argue that government bureaucrats often promote inefficiency and negatively affect the quality of the products which eventually shift the cost to the customers. The growing significance of foreign trade stresses the need to be competitive and the removal of regulated trade restrictions.a. Effects of Deregulation: (i) Temporary dislocations take place and deregulation of an industry. (ii) Inefficient firms may go out of business and merger activity increases, which may reduce competition. (iii) Increased competition may produce rapid expansion which may create excess industry capacity. (iv) Management must start practicing cost control, maintaining profit margins, improving productivity and producing marketing and pricing strategies. (v) A wider range of products, lower consumer prices and rapid innovations usually result. (vi) Since there are no longer any companies which suffer from ties, consumers in small or high-cost markets have to bear increased price and/or accept decreased service to cross-subsidize unprofitable routes or service standards.7.Cost Accounting Standards Board: This government board regulates the standards and rules manipulating allowable and unallocated cost accumulation and reporting. This applies to businesses and universities billing governmental entities under cost in addition to contractual arrangements.8. Business/Union Influence on Legislation: Under the Federal Election Campaign Act and the Labor Management Relations Act, corporations and labor unions cannot make direct contributions to federal election campaigns, political parties, or candidates. Political action committee (PAC) is an exceptional case. Both corporations and unions may use their funds to organize and administer a PAC. The organization must disclose cash contributions and in-kind services given to a PAC.C. Anti-Trust LegislationThe Adam Smith free-market economic model assumes the most efficient allocation of resources. The anti-trust laws enforce the aims of protecting and preserving the free-market system as well as vigorous competition. The price mechanism determined in the market place by a large number of independent competitive business firms guarantees that the consumer's welfare is best served.wsuits and Exemptions: Lawsuits may be brought by a private party, a state government, theJustice Department or the Federal Trade Commission (FTC). Certain firms and groups are exempted from the anti-trust laws. Instances include labor unions, some sports associations, patents, copyrights and trademarks.Regulated industries are covered by the anti-trust rules to the extent determined by statute and the courts.II FISCAL POLICYA. GNP and The Circular Economic ModelWorkers are awarded for their labor with income which they use to buy goods and services. This generates a circular flow. The total expenditure on consumption goods and investments including consumers, business, government and foreign expenditures are all included in the calculation of aggregate demand. Consumer spending accounts for about 2/3 of the total. Savings (or non-consumption of income) equals investments.Gross National Product (GNP) includes the total market value of all goods exchanged. Exchanges of goods in the intermediate stages are excluded as are second-hand sales and purely financial exchanges. These measures are not adjusted for population or price level changes.i.Aggregate Measures: The following aspects are measured to show the relationship between GNPand Disposable Personal Income.a. Personal Income:N1 - (Corporate undistributed profit + income taxes + Social Security payroll taxes) +Government transfer payments: Personal Income (PI)b. Disposable Personal Income:PI - Individual direct taxes (personal income taxes) = Disposable PersonalIncome(DPI)c. National Income:NDP - Indirect business taxes (sales tax + employer paid taxes) -- National Income (NI)d. Gross National Product:World-wide output produced by U.S. corporations and individualse.Gross Domestic Product:GNP - Output produced outside the U.S. = Gross Domestic Product (GDP)f. Net Domestic Product:GDP - Depreciation = Net Domestic Product (NDP)2. Uses of Disposable Personal Income: Disposable Personal Income (DPI) is used Consumption,Savings and/or Interest Payments.3. Leakage and Injections: Net imports, taxes and savings are all calculated in circular flow leakages. Injections into the circular flow include net exports and government spending or investments.4. Income and Expenditure Approaches to Determine GNP: GNP can be determined by measuring either the value of income or the amount spent to purchase the year's goods and services total output.a. Income Approach: The total income stream paid the input components used to produce goodsand services determines GNP.Indirect Business TaxesUndistributed Corporate ProfitsProprietors' IncomeEmployees' WagesRentCorporate Income TaxesDividendsInterestCapital Consumption Allowance (estimate of the amount of capital equipment used upin the current year's production)b. Expenditure Approach: The sum of the following components which represent all spending categories for final goods and services also determine GNP:Gross Private Domestic Investment (by businesses)Government Purchases of Goods and Services (transfer payments are excluded)Personal Consumption Expenditures (by households)Net Exports of Goods and Services (positive) or Net Imports (negative)5. Real vs. Nominal GNP:Nominal GNP calculates the produced output of goods and services produced within a given year at current prices for that year. Real GNP calculates the output at the prices prevailing within a given base year in order to isolate output changes in the measurement. The increase of real GNP from one year to the next is regarded to be the annual growth rate of the economy.B. Consumption~ Savings and Investment Analysis1. Marginal Propensity to Save (MPS) = Change in Savings = Change SChange in Income Change Y2. Average Propensity to Save = Savings =SIncome Y3. Marginal Propensity to Consume (MPC) = Change in Consumption = Change CChange in Income Change Y4. Average Propensity. to Consume = Consumption = CIncome Y5.Consumer Confidence: The individual consumer accounts for about 2/3 of the purchasing power which supports the U.S. economy. If consumers do not have confidence in the short-run economic future, they may reduce consumption.6. Low Savings Rate: There is a relatively high consumption function and hence a low savings rate. Interest (the return to savings), dividends, as well as capital gains. However, the implementation of retirement plans generally defers tax. The government's large trade deficits are a form of national dissavings, which further aggravates the problem.a.Effect:(i)Creating a scarcity of domestic equity capital.(ii)Resulting in lower productivity.(iii)Low savings restrict investments resulting in less new capital equipment it is moredifficult to replace outdated facilities.(iv)The situation places the U.S. at a competitive disadvantage in internationalmarkets.(v)The easy availability of consumer credit fosters a "buy now, pay later" attitudeamong household members.7. Productivity: If output per labor hour increases, GDP may increase automatically without inflation. Due to downsizing and increased computerization, there has been sustainable and non-inflationary growth since 1995. There was an annual GDP increase of 4% in 2001-2002 while consumer prices rose 1.5%; this suggests a 2.5% productivity increase; some economists believe this may rise to 5%.8.Capital Goods Investment: Production equipment or trucks are long-term assets used in a business. The buyer is required to raise capital for the purchase. Net capital goods investment deducts depreciation. A firm pays for investments with internal working capital and/or borrowing.C. Multiplier Effect1. Formula:1 or 1 x Stimulant.MPS I-MPC2. Example: If the marginal propensity to consume (MPC) is 0.8, the marginal propensity to save (MPS) is 0.2 and the stimulant is 4 then1 x Stimulant 1 x 4 1 x 4= 5x4 = 201-MPC = 1 - 0.8 = 0.2of which 80 percent (16) will be increased GDP and 20 percent (4) will be savings.D. Economic Cycles1.Four Stages to Cycle:(i)Recovery or expansion (increase in economic activity and willingness to risk newinvestments);(ii)Peak or plateau (robust economic activity);(iii)Downturn or recession (slowing economic activity); and(iv)Trough (low economic activity with underutilized productive capacity and lowbusiness inventory levels).2. Leading Indicators: The Commerce Department's index of leading indicators is consisted of 10sets of economic and financial statistics. Historically, the overall economic cycle has sustained 6 to 9 months.Three consecutive monthly gains or drops are considered as a signal of an impending change. Consumer confidence, the price of common stock, initial claims for unemployment benefits, average hours worked per week, building permits, orders for new plant and equipment, as well as the money supply are the best known indicators.Durable goods orders - automobiles, refrigerators, etc., that will last more than three years - are watched carefully as they increase in a recovery.3. Lagging Indicators:Inflation rates, interest rates, unemployment rate, average duration ofemployment and unit labor costs are all lagging indicators.4. Accelerator Effect:A stimulated spending increase targeted to business inventory and capitalequipment expenditures will influence aggregate income level greater than one targeted to other segments of the economy. This follows because such stimulants directly affect businesses' need to increase employment. The accelerator effect may thus further expand or dampen the multiplier effect depending on the position of the overall economic cycle. There is more wide fluctuation in investment spending.5. Stabilizers:Stabilizers diminish the amplification of the economic cycle. Stabilizers supportdemand during contracting periods and restrict demand during expansion periods. Price supports, transfer taxes, unemployment insurance and taxes on inc6me or corporate profits are included in this category.E. Employment and Unemployment1. Frictional Unemployment: Frictional unemployment refers to the normal turnover of labor in adynamic economy. This is supply-oriented and is a short-term temporary situation for the individual worker. New entrants to the labor market, those switching positions, unemployed seasonal workers, and workers fired for cause are included in this category. Workers in the frictional unemployment category often move on to better jobs.2.Structural Unemployment: Structural unemployment is caused by changes in the economycausing skills and occupations to become obsolete. References include corporate downsizing, changes in consumer preferences, technology, industrial segment composition and the continual shift to off-shore geographical locations of manufacturing jobs. Productivity increases (output per hour) may also reduce the demand for labor. After a short-term downturn ends, structural unemployment endures.F. InflationThe Phillips Curve states that there is negative correlation between inflation and unemployment. There will be both higher inflation and lower unemployment levels resulting from excess demand. If there is near full employment before the stimulation, the increase in demand will primarily increase the price level. Adversely, during a recession, inflation should fall as unemployment increases.1. Types of Inflation:a. Cost-Push Inflation: This occurs when the market power of big unions results in increases in wages which exceed the increase in productivity (output per hour increased at 2.5% in 2003). Similarly, the costs of other inputs into the production process may rise less fast than their increases in productivity.b. Profit-Push Inflation: Large businesses with inelastic demand curves raise their prices to increase profits.c. Demand-Pull Inflation:. It results from the aggregate demand for goods and services exceeding the country's productive capacity to supply them. The resulting "too many dollars chasing too few goods" causes to higher price levels.2. Measurement:Price Index: A price index is the amount of money required to purchase a "market basket" of goods and services. The percentage rate of inflation is calculated as follows:(Price index for current period) - (Price index for immediate prior period) x 100(Price index for immediate prior period)a. Implicit GNP Deflator:Inflation may also be measured by the implicit GNP deflator that converts nominal to real GNP. This measure values all the goods and services produced by the entire economy (not just a market basket) as follows:b.Producer Price Index: The PPI tends to lead both the WPI and the CPI. The core rate of the PPI excludes the often-volatile food and energy costs. For 2003, the WPI and PPI fell at an annual rate of .6%. One would expect the CPI and PCE to follow this decrease.c.Consumer Price Index: T he Consumer Price Index (CPI) reported by the Department of Labor are the most probably used price index. Items in a typical consumer's fixed market basket of goods and services they have historically purchased are mearsured in CPI.d. Personal Consumption Expenditures Index: Some economists argue this shopping list approach is a more accurate measure of the daily cost of living than the CPI's "fixed market" basket approach. The PCE tracks the people actually buy things as their spending patterns change when one item becomes cheaper or pricier relative to substitute items.e.Wholesale and Producer Price Indexes: The WPI and PPI tracks wholesalers' and producers' pricing and tends to lead the CPI and PCE.× 1003. Indexing: Indexing links current or future payments (of taxes, wages, transfer payments or social service benefits) to past inflation rates. One example is cost of Living Adjustments (COLA). Indexing Fuels inflationary spirals. This may lead to the institutionalization of inflation since the indexed segments of the economy no longer demand that the government attempt to moderate inflation.4. Deflation: Deflation helps consumers since goods become progressively cheaper. The risk in purchases are deferred hence restricting economic activity. However, holders of real assets suffer. Interest rate stimulated monetary policy becomes less effective. Secured creditors, such as bondholders, gain relative purchasing value. Productivity, the growth of e-commerce, and the growing cheap foreign imports will continue to eliminate middlemen and promote lower prices. Import prices will be raised.5. Importance:(i)Inflation hurts fixed incomers, but helps leveraged debtors.(ii) A stable price environment reduces the uncertainty of business planning and extends the planning horizon.(iii)The condition of inflation and recession together is called stagflation.(iv)U.S. inflation is critically important in financing the fiscal and foreign trade deficits.G. Political ConsiderationsThe political system does not consider revenue and expenses together. This has led to the development of vested interest beneficiary groups who lobby for their specific program. Fiscal policy equals revenue (taxation and other governmental charges) minus expenditures. This is a function of our Internal Revenue Service Code and the national budget passed by the Congress. The proportion of the budget going to non-discretionary requirements grows per year.H. The Deficit and Its Implications1. The National Debt: The national debt constitutes of the total stock of governmental bonds (or claims on the government) outstanding. The deficit amount is borrowed from the private sector, pension funds and government agencies such as Social Security by the Government. Government borrowing now absorbs two-thirds of all nonfederal savings. This drives interest rates up and crowds out private sector borrowing, hence reducing the number of profitable investments and creating new employment. Increasingly the private sector portion of the borrowing is offered by foreign individual investors, institutions and central banks.a. Annual Debt Service:The necessary annual interest payments have occupied 17% of the federal budget. It crowded out discretionary disbursements. The 2002 debt service was $240 billion net interest. This is the current price of prior debt.b. Real Gross Interest: The actual net interest debt service understates the problem since it fails to include any return for the internal use of funds. Gross interest is a more accurate measure of the true cost. Gross interest reflects the debt the Government owes itself (Social Security surplus used for general expenditures, off-budget financing, period shifting, creative accounting, etc.) which was about $120 billion in 2003.c. Percentage of GDP: In 2003 the annual deficit was 3.5%; the national debt was 37% in the U.S. This compares to 10% for Japan, 40% for England, 42% for Germany, 70% for Canada, and 110% for Italy. Many economists feel the annual deficit and national debt as a percentage of GDP is a more accurate measure of the public burden the deficit imposes on the private markets.2. The Solution: Federal spending has risen from 15% of GDP in 1950 to 25% in 2003. The annual deficit and entitlements (Social Security, Medicare, Medicaid, and pensions for retired federal and military employees) constitute 66% of non-interest spending and are expected to balloon after 2005. Congress does not consider revenue and expenses together.a. 1990 Controls:In 1990, caps were placed on all Federal spending categories; spending increases are now only possible if cuts are offsetted from the same category or new tax increases. On every October 15th, automatic sequesters will reduce selected governmental spending programs on a pro-rata basis if no agreements of a voluntary restraint among the Executive and Legislative branches can be achieved.b. Balanced Budget Agreement: In 1997, the White House and Congress brokered a deal to balance the federal budget. This follows a steady reduction in the deficit. During the next five years, both tax cuts and spending reductions are to be implemented. The balancing projection also assumes the economy will not go into a recession. The balanced budget does not cut entitlements such as Social Security, Medicare and Medicaid.3.The Future: The most important question is whether the Republicans will make permanent the 2003 income tax reduction and elimination of the estate tax and dividend tax. The wealthy will be primarily benefit since they have a very low marginal propensity to consume (the 2003 tax cuts cost $179 billion). The 2004 deficit may exceed $500 billion. Retiring baby-boomers will be turning to Washington for Social Security and Medicare in a few years.I. Taxation Methods and Theories。