Sep 28 2012

## Bad crop equals higher incomes for farmers – what’s up with that?

Despite Record Drought, Farmers Expect Banner Year

Listen to the story above. According to the report, farmers in the American Midwest have seen their incomes reach new highs this year, despite the terrible harvest resulting from a nationwide drought.

This is curious. The drought starved crops of water, forcing farmers to harvest in the middle of the growing season, essentially destroying much of their harvest for the year. So the question is, how does a BAD harvest result in GOOD incomes for farmers?

Believe it or not, the answer to this riddle requires an understanding of elasticity; specifically, price elasticity of demand (PED). PED measures the responsiveness of consumers to a change in the price of a good. The PED for a good can be measured between two prices by using a simple formula:

• PED = the percentage change in the quantity of a good demanded divided by the percentage change in the good’s price.

The result of this calculation, which is known as the PED coefficient, will always be a negative number. Why will the PED coefficient be negative? Think back to the law of demand, which states that there is always an INVERSE relationship between price and quantity demanded of a good. Since PED measures how much the quantity demanded changes in response to a particular change in price, the coefficient of PED must be negative, since price and quantity always change in the opposite direction.

So back to our farmers who are enjoying high incomes despite the terrible harvest. What does this have to do with PED? Well, that’s what I want you to figure out. In the comments below, explain how an understanding of price elasticity of demand can help us understand why farmers whose crops were largely destroyed by drought ended up earning higher incomes than they expected.

Sep 27 2012

## Understanding the Consumer Price Index – the Fed’s “Drawing Board”

MV=PQ: A Resource for Economic Educators: Some Classroom Resources

Special thanks to Tim Schilling at MV=PQ blog for pointing out the Cleveland Fed’s interesting video series called the “Drawing Board”.

This video introduces the concept of Consumer Price Index as a measure of inflation in the United States, shows how CPI is calculated, and then goes into a bit more detail than perhaps the AP or IB student needs when it introduces a new method of measuring inflation used by the Fed called “median inflation”.

AP and IB students can benefit most from watching up to 4:12. In this first half of the video the CPI is defined, its measurement demonstrated, short-comings discussed and the “core CPI” explained.

Discussion Questions:

1. Why does the Bureau of Labor Statistics weight different items included in the measure of the consumer price index? What type of good gets a greater weights than others?
2. What are some of the purposes the CPI figure serves? Why do we care about changes in the price level in an economy?
3. What is one short-coming of the traditional method used for measuring the inflation rate using CPI?
4. Why did the BLS decide exclude oil and food prices from its “core CPI” figure?

Sep 27 2012

## Deflation: why lower prices spell doom for any economy!

The Fed should focus on deflation | The greater of two evils | The Economist

Deflation: a decrease in the general price level of goods and services of an economy. Sounds great, right? Lower prices mean the purchasing power of our income increases, making the “average” person richer! On the surface, it could be concluded that deflation may actually be a good thing. And in some cases, it is!

If prices of goods are falling because of major technological advances (think of the price of cell phones and laptop computers over the last 20 years) or because of massive improvements in the productivity of labor and capital (think of the price of manufactured consumer goods during the Industrial Revolution), then deflation could be considered a sign of healthy economic growth. Put in terms an IB or AP Economics student should understand, a fall in prices caused by an increase in a nation’s aggregate supply is good, since it is accompanied by greater levels of employment and higher real incomes. But if the fall in prices is caused by a decline in spending in the economy (in other words, by a decrease in aggregate demand), the consequences can be catastrophic.

It just so happens that the United States, Great Britain, and my own home of Switzerland are all faced with demand-deficient deflation at this very moment. I’ll allow the Economist to elaborate:

…With unemployment nearing 9% (in the United States), economic output is further below the economy’s potential than at any time since 1982. This gap is likely to widen. House prices are not part of America’s inflation index but their decline is forcing households to reduce debt , which could subdue economic growth for years. As workers compete for scarce jobs and firms underbid each other for sales, wages and prices will come under pressure.

So far, expectations of inflation remain stable: that sentiment is itself a welcome bulwark against deflation. But pay freezes and wage cuts may soon change people’s minds. In one poll, more than a third of respondents said they or someone in their household had suffered a cut in pay or hours…

Does this matter? If prices are falling because of advancing productivity, as at the end of the 19th century, it is a sign of progress, not economic collapse. Today, though, deflation is more likely to resemble the malign 1930s sort than that earlier benign variety, because demand is weak and households and firms are burdened by debt. In deflation the nominal value of debts remains fixed even as nominal wages, prices and profits fall. Real debt burdens therefore rise, causing borrowers to cut spending to service their debts or to default. That undermines the financial system and deepens the recession.

From 1929 to 1933 prices fell by 27%. This time central banks are on the case. In America, Britain, Japan and Switzerland they have pushed short-term interest rates to, or close to, zero…

…inflation is easier to put right than deflation. A central bank can raise interest rates as high as it wants to suppress inflation, but it cannot cut nominal rates below zero… In the worst case, rising debts and defaults depress growth, poisoning the economy by deepening deflation and pressing real interest rates higher….Given the choice, erring on the side of inflation would be less catastrophic than erring on the side of deflation.

Discussion Questions:

1. Deflation poses several threats to an economy that is otherwise fundamentally healthy, such as the United States’. What are some the threats posed by deflation?
2. The expectation of future deflation can have as equally devastating effect. Why is this?
3. What evidence does the article put forth that an economy experiencing deflation may eventually “self-correct”, meaning return to the full employment level of output in the long-run?
4. Why don’t governments and central banks just sit back and let the economy self-correct? In other words, why are fiscal and monetary policies being used so aggressively by the US, Great Britain and Switzerland during this economic crisis?

Deflation or Inflation:Watch the video below, see if gives you any clues as to the causes and effects of deflation. What do you think John Maynard Keynes would say in response to the deflationary fears expressed in the Economist article?

Sep 20 2012

## Measuring the Macroeconomic Objectives – research activity

The activity below is to introduce Economics students to the three primary Macroeconomic objectives of any government or policy making body. These are :

Full employment of the nations work force: This means that nearly everyone who wants to work in the country is able to find a job. It does not mean that there is no unemployment, rather that the unemployment that does prevail in the economy is voluntary, i.e. it exists because workers are simply not willing to work at the prevailing wage rate. If there is involuntary unemployment in the economy, then the country is not meeting its macroeconomic objective, and there is likely a recession caused by a lack of overall demand (aggregate demand) for the nation’s goods and services.

Resources for learning about Full Employment:

Price level stability: Changes in the average price level of goods and services in the nation are measured by calculating inflation, commonly using a consumer price index to do so. Low and stable inflation is one of the macroeconomic objectives since price level volatility (high inflation or deflation) has several harmful effects on a nation’s households and business firms. Keeping inflation low and stable promotes a healthy environment for achieving business investment, full employment and economic growth

Resources for learning about Price level stability:

Economic growth: The third macroeconomic objective is to increase the output of the nation’s goods and services year after year. Economic growth refers to the increase in real Gross Domestic Product (GDP) and can be measured by finding the total value of a nation’s output one year, comparing it to the previous year, and adjusting it for any changes in the price level between the years. Economic growth is a desirable goal because it generally means that incomes are rising and people’s lives are getting better. Of course, GDP only measures the physical output of goods and services, and does not include many non-economic variables that also should be considered when measuring people’s well-being. But rising incomes and output are deemed worthy goals since they are associated with rising living standards.

Assignment: Complete the readings and online activities above. Then use the data in the table linked below to answer the quesitons that follow.

Questions:

1. Calculate the unemployment rates for each of the years in the table. Describe what happened to unemployment over the years displayed.
2. Calculate the inflation rates between each of the years in the table. Describe what happened to inflation over the years displayed.
3. Calculate the Real GDP for each of the years in the table.
4. Calculate the Real GDP growth rates between each of the years in the table. Describe what happened to real GDP from one year to the next in the years displayed.
5. Describe the relationship between the inflation and unemployment rates you calculated for each of the years. Is there any correlation in how the figures change from year to year?
6. Based on your analysis of the data above, to what extent has the United States succeeded in achieving its three macroeconomic objectives of:
• Full employment?
• Price level stability?
• Economic growth?

• ## Order Welker’s books

for IB Economics

for AP Macro