February 23 to 27
February 23
Q1: I still don't understand the difference between the GDP Price Deflator and the CPI (Consumer Price Index).
A: The GDP Price Deflator is a measure of the change in prices of those goods Americans actually buy. So, assume for example, there are only three commodities produced in the economy and in year one producers make and consumers buy equal quantities of all three goods, then in year two prices double for goods 1 and 2, but stay constant for good 3. If in year two consumers bought only good 3, then the GDP Deflator would stay constant. Assume that, for the CPI, the Department of Commerce has tracked a basket of goods under the assumption that Americans will buy equal amounts of all three goods. The CPI will register a substantial increase in year two since two of the three goods have doubled in price. That's the difference. The CPI is tracking price changes of a fixed basket of goods (In this case, the basket is comprised equally of three goods -- assuming that the average household continues to split its expenditures in this way) so it's a true measure of change in prices over time, while the GDP Price Deflator will reflect the price changes of whatever consumers actually buy -- if they buy more of goods whose prices have fallen, then the GDP Deflator will show a much lower rise in general prices.
Q2: Has the minimum wage rate taken into account inflation in order to successfully allow people a better cost of living?
A: The Federal Minimum Wage is not indexed to the rate of inflation. It has remained constant since 1997 at $5.15. Congress has yet to pass a higher minimum wage. This means that workers making the minimum wage have a lower standard of living (i.e., a lower real income).
Q3: If electronic goods are in such great demand then why do prices decrease? And therefore shouldn't college tuition decrease because it's in such great demand?
A: There is the possibility that production costs fall proportionately more than demand rises. This would mean that the supply curve shifts farther to the right than the demand curve. If you try this -- shift demand to the right, then shift supply by a greater amount to the right -- you'll see that equilibrium price falls. So, how did that happen with electronic goods? Production of durable electronics have increasingly been shifted to third world countries where they can be produced at a fraction of the cost. So, prices have come down while demand has been rising. If there had been an increase in the number of colleges (or a reduction in the costs of providing a college education, e.g., faculty salaries fall) relative to the rise in demand for a college education, then tuition might have fallen.
Q4: I don't think Martha Stewart should spend $15,000 for an umbrella stand. It is morally wrong in my opinion.
A: It was $17,000 for a weekend driver -- an amount she charged as a company expense. The $15,000 umbrella stand was bought by another C.E.O. under investigation.
Q5: Can you explain the function of hedge funds?
A: Is this a test? They are instruments that allow investors to use options and futures (right to buy at a set price at some future date, and guarantee by a second party to provide specific quantities of a security or commodity at a set price in the future) to avoid risks of asset price fluctuations. Remember, this is a macroeconomics class, not finance.
Q6: Why exactly does inflation occur? What makes the price level rise?
A: We have identified two types of inflation: Demand Pull and Cost Push. If aggregate demand rises faster than producers are willing and able to produce final commodities and services then general prices will rise. That's demand pull. If costs of production rise (e.g., the price of petroleum) then aggregate supply will shift back to the left and the general price level will rise independent of changes in aggregate demand.
Q7: With CPI, how do scholarships, grants and loans interfere with the real price it would cost? What about coupons and discounts? Do these examples assume the families are on a fixed budget?
A: The CPI may track discounted tuition costs, it depends on the way they ask the questions. Since it is a survey of a cross-section of colleges of all kinds, it is unlikely that it gets to that level of detail. As well, coupons and discounts may be accounted for in determining the price of other commodities but not at the level of individual transactions. So, for example, when the automobile companies announce price changes, those will be reflected in the CPI, but it is unlikely that changes in finance terms (0% financing or rebates, for example) will. The price indexes assume nothing about consumer's incomes. Remember, in the aggregate, the sum of incomes equals the total value of output. One person's income may have gone up more than the cost of living, while another's has increased by less than inflation or even gone down.
Q8: Do large companies tend to postpone long-term spending obligations during times of larger consumer buying such as holidays? Simply because sales could jump or flop? Or do they wait to more stable times -- say summer months?
A: Investment decisions in durable goods are based upon anticipated future changes in final product prices, cost of investment goods and the cost of financing. Pessimism or optimism about the course of the future economy will determine whether, as Keynes said, businesses have the "animal spirits" to invest in new plant and equipment. Changes in short-term investment like adjustments in inventories occur on the basis of expected fluctuations in sales (holiday spikes etc) and short-term financing terms.
Q9: I don't understand the redistributive effects of inflation. Can you explain it in more detail?
A: People on fixed incomes (their money incomes remain constant -- if you make $50,000 this year and every year into the future, you're on a fixed income) will experience a continuous decline in real income. People whose incomes rise faster than inflation will experience an increase in real income. So, the distribution of real income (purchasing power of your income or the ability to buy goods) has shifted towards those whose incomes have increased faster than inflation. They have a higher standard of living. It is a redistribution of real income.
February 25
Q1: I'm still very confused about aggregate demand curves. Can you help more?
A: Aggregate demand describes the relationship between the general price level and the demand for total output. As the general price level falls, a given sum of money a person has in savings can buy more goods, hence the person feels wealthier and will spend more on goods and services (the wealth or real balances effect). As the general price level falls relative to prices on foreign goods, Americans will buy more U.S. goods and fewer foreign goods (the foreign trade effect). As the general price level falls, it also means interest rates tend to fall, so people will borrow more and spend it (the interest rate effect). So, the aggregate demand curve is negatively sloped -- as the general price level falls, the demand for total output will rise. (Schiller 159-160) Independent of changes in the general price level, the aggregate demand curve can shift to the right (increase) or to the left (decrease). If Americans anticipate a coming recession, consumer confidence will fall and they will cut back on spending (aggregate demand shifts left). If the exchange rate of the Yen in terms of the dollar rises, the Japanese will buy more American goods and the aggregate demand curve will shift to the right (increase). The intersection with the aggregate supply curve will determine equilibrium output. This, however, may be at an output that is less than the output that will fully employ the labor force. Keynes would have argued for increasing government spending or lowering the interest rate, both of which would shift aggregate demand to the right -- closer to full employment. The supply siders would argue for reducing regulations on business (e.g., get rid of those inconvenient clean air standards) and lowering taxes on corporate profits, causing the aggregate supply curve to increase (shift right). This might also cause us to move closer to a fully employed labor force. I hope that helps.
Q2: What does Ceteris Paribus mean?
A: Everything else remains the same. So, you might say "if hourly wages rise, ceteris paribus, unit production costs will rise." The reason you would use the term in that instance is that if productivity (output per hour) increased along with hourly wages, then unit production costs might stay constant or even fall.
Q3: The sudden increase [vertical turn] in the aggregate supply curve is still hazy.
A: As the economy approaches full employment, it becomes harder to find workers (a labor shortage) and wages are forced up. This rapid rise in wages causes sharp increases in production costs which require producers to increase prices. However, at the same time, they are unable to increase output by much -- remember the economy is close to full employment. One way to see this clearly is to imagine the extreme case where everyone had a job and the economy was producing as much as it possibly could. But individual producers still want to produce more, so they bid wages up and attract workers away from their current employers. No more goods will be produced (the workers lured away will simply be producing the same quantity of goods but now for different employers) but producers will have forced prices to rise. That's the reason for the vertical segment of the aggregate supply curve.
Q4: If price stability is more important than unemployment, what would be more important -- an increase in GDP of 3 percent or a 20 percent unemployment rate? How can this properly be rationalized in an effort to hurt people, especially with the social problems that can arise?
A: Greenspan doesn't make that extreme an argument. It is more a matter of emphasis, although your concern is legitimate. He believes, as any good banker would, that inflation threatens the value of the currency and therefore the soundness of the nation's financial institutions. A little unemployment ensures that wages don't get out of hand and that prices are kept in check. Greenspan has been very generous during the Bush years -- he has uncharacteristically reduced interest rates time and again. This seems to contradict his bankerly instincts for a conservative tight money policy. He clearly doesn't want to preside over a Bush recession. This is a precise reversal of his policies during the last year and a half of the Clinton administration. Many believe that his sharp interest rate hikes were what brought on the sudden collapse of the economy in the fall of 2000. Did he want to deliver the election to Bush? Who knows? What is obvious, is that inflation was no more a threat then than it is now -- as a matter of fact, inflation is slightly higher now due to increases in petroleum prices.
February 27
Q1: Which is better, saving our money or putting it back into the economy through spending?
A: Saving is a virtue for the individual almost always and it is also a way to provide for business investment in added capacity -- the more savings, the lower the rate of interest and the more likely businesses will borrow and spend for new plant and equipment, which means more jobs. It all sounds good, right? But there are two sides to this question. Increased savings means reduced spending for consumer goods. So, the key is to keep the savings rate at about the level that businesses want to invest in new plant and equipment. That will mean that the breakdown between the production of consumer goods and the production of capital goods (equipment, machines, factories etc) will just match the spending on consumer goods and the spending on capital goods.
Q2: Which of the schools of thought seems the most accurate, the most frequently?
A: There are only very long answers to this question. I'll say two things: 1) It depends on who you talk to and 2) at a given time, one or the other seems to have a better argument. Right now (hey, I'm saying three things!), I would say that Keynesian economics is on the rebound.
Q3: Can we do some examples of APC, MPC and MPS?
A: Here is a quick example:
(a) (bYd)
Income Constant Consumption APC MPC MPS
$1,000 200 800 1.0 .80 .20
2,000 200 1,600 .90 .80 .20
3,000 200 2,400 .87 .80 .20
4,000 200 3,200 .85 .80 20
The constant (a in the consumption function) is the autonomous consumption -- that which occurs when income is zero. As income rises from zero, consumption will rise by .80 (in this case) of any rise in income -- that's the so-called income-dependent Consumption (bYd in the consumption function).
Q4: I don't think it's the amount of money/disposable income people have that determines how much people save -- most people save for protection -- against medical emergencies/accidents or for taxes!
A: That is part of why people save, of course. However, the fact remains a person who receives a mere subsistence income will be saving nothing at all. As the person's income rises from subsistence, he/she will be saving a positive amount. Even Keynes' dissavings argument was proved correct during the depths of the Great Depression. People spent more than they were earning in income -- drawing down on their savings, then when WWII began, the level of savings soared.
Q5: Could you explain the diagrams of disposable income and consumption?
A: On page 181 of Schiller's text, you can see the consumption function diagram. The constant (a) is 50. That is the amount Justin will spend even if he receives no income. As his income increases he spends $.75 of every additional dollar. That is reflected in the component bYd (mpc x disposable income). When income rises to 100, he spends an additional 75 for a total of 150. 150 = a + bYd = 50 + .75 x 100. When his income rises to 200, he spends a total of 200. 200 = a + bYd = 50 + .75 x 200. You can see that eventually the savings gap begins to open up.
Q6: Why is disposable income Yd?
A: If it were D, as you suggest, it would be confused with the aggregate demand curve. Y, without the d, is the symbol for GDP.
Q7: I have heard of stagnation, but stagflation?
A: It's a term coined during the 1970s to describe the simultaneous presence of high rates of inflation and unemployment -- something that could not be explained by Keynesian economics -- at least very readily. Stagnation + Inflation = Stagflation. Not very creative, but then that was the 70s.