Notes and teaching tips: 6 ,8, 17, 19, 20, 28, 32, and 36.
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Don’t skip the questions in a rush to get to the economic way of thinking. Open your students’ eyes to economics in the world around them. Ask them to bring a newspaper to class and to identify headlines that deal with stories about What, How, and For Whom. Use Economics in the News Today on your Parkin Web site for a current news item and for an archive of past items (with questions). Pose questions and be sure that the students appreciate that they will have a much better handle on questions like these when they’ve completed their economics course.
Talk about Adam Smith and the Wealth of Nations.
Note that this book was the first systematic attempt to address this big question and that economists have been trying to answer it ever since.
You might like to mention that several Nobel Prizes have been awarded to economists who have worked on the question including Ken Arrow, John Hicks, and Gerard Debreu, as well as John Nash of “Beautiful Mind” fame.
Notes and teaching tips: 5, 6, 17, 21, 37, 38, 41, 57, 58, and 62.
To view a full-screen figure during a class, click the red “expand” button.
To return to the previous slide, click the red “shrink” button.
To advance to the next slide, click anywhere on the full screen figure.
Applying the principles of economics to interpret and understand the news is a major goal of the principles course. You can encourage your students in this activity by using the two features: Reading Between the Lines and Economics in the News.
(1) Before each class, scan the news and select two or three headlines that are relevant to your session today. There is always something that works. Read the headline and ask for comments, interpretation, discussion. Pose questions arising from it that motivate today’s class. At the end of the class, return to the questions and answer them with the tools you’ve been explaining.
(2) Once or twice a semester, set an assignment, for credit, with the following instructions:
(a) Find a news article about an economic topic that you find interesting.
(b) Make a short bullet-list summary of the article.
(c) Write and illustrate with appropriate graphs an economic analysis of the key points in the article.
Use the Reading Between the Lines and Economics in the News features in your textbook as models.
You can have some fun and generate some discussion by getting the students to think about what life might be like after another 200 years of economic growth. Provide some numbers: In 2006, income per person in the United States was about $100 a day. In 1806 it was about 70¢ a day, and if the past growth rate prevails for another 200 years, in 2206 it will be $14,000 a day. Emphasize the magic of compound growth. If they think that $14,000 a day is a big income, get them to do a ballpark estimate of the daily income of Bill Gates (about $20 million!) Encourage a discussion of why scarcity is still present even at these large incomes.
Be sure to cover the “Standard of Living Tradeoff” idea that the students met in Chapter 1 and that they can now think about with the more powerful tool of the PPF.
If you wish, connect the discussion of efficiency with that of growth. Ask the students to explain what determines the efficient growth rate (not in text).
Classroom activity
Check out Economics in Action: Hong Kong Catching Up to the United States
The gain from trade is a real eye-opener for students. Their first reaction is one of skepticism. Convincing students of the power of trade to raise living standards and the costs of trade restriction is one of the most productive things we will ever do.
Here are some ideas to drive home the idea of comparative advantage:
Why didn’t Billy Sunday do his own typing? Billy Sunday, an evangelist in the 1930s, was reputed to be the world’s fastest typist. Nonetheless, he employed a secretary who was a slower typist than he. Why? Because in one hour of preaching, Billy could raise several times the revenue that he could raise by typing for an hour. So Billy plays to his comparative advantage.
Why doesn’t Martha Stewart bake her own bread? Martha Stewart is probably a better cook than most people, but she is an even better writer and TV performer on the subject of food. So Martha plays to her comparative advantage and writes about baking bread but buys her bread.
Why doesn’t Vinnie Jones play soccer? Vinnie Jones is one of the world’s best soccer players (although now getting a bit old). But he stopped playing soccer and started making movies some years ago. Why? Because, as he once said, “You go to the bank more often when you’re in movies.” Vinnie’s comparative advantage turned out to be in acting.
The costs of trade restrictions need to be driven home. The 2002 steel tariff increase and the EU response is a good story to use.
Classroom activity
Check out Economics in the News: Energy Independence
The point of this short section is to lay the groundwork for the next chapter on demand and supply. You can cover it quickly or you can use it as a peg on which to hang a discussion of some of the big-picture of the underpinnings of our subject. Some examples follow:
The “Invisible Hand”: How self-interested individuals promote prosperity for all. Explain that in economics, we take human nature as given (in contrast to political science, philosophy and some other fields) and assume that people are self-interested. Note if you wish that self-interest does not mean selfish.
If everyone is self-interested, how are people encouraged to specialize and exchange to promote prosperity for all? Building on the Liz and Joe example in the chapter, you can explain how specialization and exchange achieves a higher standard of living that does self sufficiency. So self interest promotes specialization and exchange.
But for specialization and exchange to work, people must be able to trade. That is why property rights and markets are so crucial.
Property Rights and Markets: The key to promoting socially beneficial activity. To reap the gains from specialization, people need access to markets in which voluntary exchange can take place. Markets work only if property rights are established and enforced.
Notes and teaching tips: 5, 16, 27, 39, 45, 48, 52, 53, 55, and 56.
To view a full-screen figure during a class, click the red “expand” button.
To return to the previous slide, click the red “shrink” button.
To advance to the next slide, click anywhere on the full screen figure.
Applying the principles of economics to interpret and understand the news is a major goal of the principles course. You can encourage your students in this activity by using the two features: Reading Between the Lines and Economics in the News.
(1) Before each class, scan the news and select two or three headlines that are relevant to your session today. There is always something that works. Read the headline and ask for comments, interpretation, discussion. Pose questions arising from it that motivate today’s class. At the end of the class, return to the questions and answer them with the tools you’ve been explaining.
(2) Once or twice a semester, set an assignment, for credit, with the following instructions:
(a) Find a news article about an economic topic that you find interesting.
(b) Make a short bullet-list summary of the article.
(c) Write and illustrate with appropriate graphs an economic analysis of the key points in the article.
Use the Reading Between the Lines and Economics in the News features in your textbook as models.
The main challenge in teaching this topic is generating interest in it. Many teachers are bored by it and not surprisingly, they bore their students. If you are one of the many who lean toward boredom, start by recalling just how vital it is that we measure the value of production with reasonable accuracy. It is vital because we use GDP as the basis of measurement of the standard of living, economic welfare, and making international comparisons.
Final goods versus intermediate goods. The distinction between final and intermediate goods is one of the key points in this first section. Use some standard examples to make the key point—tires and autos, chips and computers, and so on. Also, if you want to spend a bit of time on this topic, tell your students about the Bureau of Economic Analysis (BEA) revision in the treatment of business spending on software.
The BEA began a major revision in 1998 and published the first revisions to reclassify software from intermediate to final good status in 1999. And, when the 1996 GDP was recalculated to include software, it increased by $115 billion, or 1.5 percent of GDP.
Government transfer payments, such as Social Security payments, are not part of government expenditure because government expenditure includes only funds used by the government to buy goods and services. Transfer payments are not buying a good or service for the government and so are not included in government expenditures.
Little is spent on measuring U.S. GDP. You might like to tell your students that the U.S. government spends very little on the measurement of real GDP. The BEA (in the Department of Commerce) employs fewer than 500 economists, accountants, statisticians, and IT specialists at an annual cost of less that $70 million. It costs each American less than 0.25¢ (a quarter of a cent) to measure the value of the nation’s production. For some further perspective, the National Oceanic and Atmospheric Administration (also in the Department of Commerce), whose mission is to “describe and predict changes in the Earth’s environment, and conserve and manage wisely the nation’s coastal and marine resources so as to ensure sustainable economic opportunities,” employs more than 11,000 scientists and support personnel at an annual cost of $3.2 billion!
Most of the income data used by BEA comes from IRS. Expenditure data comes from a variety of sources.
You might like to explain how the omission of illegal goods and services also leads to some misleading comparisons. For instance, the day before prohibition ended, the production of (illegal) beer was not counted as part of GDP. But the day after prohibition ended, the production of (now legal) beer counted. Ask your students to suggest two good reasons why illegal goods and services are omitted.
First, the data are hard (but not impossible) to obtain. Second, there may be the moral position that illegal activities should not be included in GDP. This latter observation can lead to an interesting discussion. Ask the students if they think that the production of, say, marijuana should be included in GDP. Some, maybe even many, of them will see no problem with this. Then ask about the production of murder-for-hire. The response, we hope, will be significantly different. Does such a good have any value?
Omissions from GDP. A discussion of omissions from GDP can arouse students’ interest. For example, you might point out that if one of your students mows her/his own lawn, the value of the student’s production doesn’t show up in GDP. But if you hire the student to mow your lawn (and if your student reports the income earned correctly to the IRS), the value of the student’s production does show up in GDP.
Why don’t we measure all lawn mowing as part of GDP? Some reasons are cost of collecting data and the degree of intrusiveness we’d be willing to tolerate. But note how little we spend on collecting the GDP data and how relatively inexpensive it would be to add some questions about domestic production to either the Current Population Survey or the Consumer Expenditure Survey.
The inclusion of the imputed rental of owner-occupied houses, but not owner-used cars and other durables, is a good example.
You might like to explain how the omission of illegal goods and services also leads to some misleading comparisons. For instance, the day before prohibition ended, the production of (illegal) beer was not counted as part of GDP. But the day after prohibition ended, the production of (now legal) beer counted. Ask your students to suggest two good reasons why illegal goods and services are omitted. First, the data are hard (but not impossible) to obtain. Second, there may be the moral position that illegal activities should not be included in GDP. This latter observation can lead to an interesting discussion. Ask the students if they think that the production of, say, marijuana should be included in GDP. Some, maybe even many, of them will see no problem with this. Then ask about the production of murder-for-hire. The response, we hope, will be significantly different. Does such a good have any value?
The Importance of the Lucas Wedge It is usually straightforward to interest students in the business cycle. But it is perhaps a bit more difficult to motivate interest in economic growth and the Lucas wedge. Yet economic growth and the Lucas wedge should be of immense importance to young students because they help determine the long-run living standard of their lives. One way to make this point clear is to ask the students whether the difference between, say, 3 percent annual growth in income versus 4 percent annual growth is important.
This difference probably does not sound important. But, suppose that the initial income was $35,000. After 10 years with growth of 3 percent a year, the income would be $47,037 and with growth of 4 percent a year, the income would be $51,809. This difference of about $4,500 might not seem like much. But point out to the students that this difference is for only ten years and that the annual difference will continue to enlarge: After 30 years with 3 percent growth, the income would be $84,954 and with 4 percent growth the income would be $113,519, a one year difference of about $40,000. And, over a 30-year working career, the total differences in income, which is the analog to the Lucas wedge, is approximately $420,000.
Over a 40-year working career, the Lucas wedge difference is over $1,000,000! Viewed from this perspective, the seemingly slight 1 percentage point difference in growth rates makes for an incredibly major difference in incomes, which should easily capture your students’ attention.
The Business Cycle Students generally are interested in the topic of business cycles, particularly if the economy happens to be in a recession when this chapter is covered. Often it is very difficult to tell the future path of the economy. Stress to the students that it is not stupidity on the part of economists that prevents us from knowing where the economy is heading. Rather it is the fact that forecasting is difficult for at least two reasons.
First, different sectors of the economy frequently send different signals. For instance, retail sales may be down, signaling a start to a recession, but housing starts may be up, indicating that an expansion will continue for a while.
Second, the data that must be used always are at least a bit out-of-date. For example, the preliminary estimate of GDP is not made until approximately six weeks after the end of the quarter, and the final revision of GDP doesn’t appear until years later.
Although economists’ forecasts are much better than those of others, forecasting GDP with complete accuracy is unlikely. Conclude by mentioning that this fact is important in later chapters when we discuss implementation of countercyclical policies.
International comparisons and PPP prices. Students sometimes see estimates of GDP per person in developing nations. Most such estimates are extremely low, and students often ask how people can live on such low incomes.
Point out that the estimate is biased downward in two ways.
First, in poor nations, more transactions do not go through a market than in rich nations. For example, transportation services in developing nations include a lot of walking, which is not counted as part of GDP. In richer nations, people ride a bus or subway and pay a fare, which is counted as part of GDP.
Second, many locally produced and consumed goods and services have extremely low prices in poor nations. For example, a haircut that costs $20 in New York might cost $1 in Calcutta. (You might get a better haircut in New York, but probably not one that is 20 times better!) Converting Indian GDP into U.S. dollars at the market exchange rate leaves this bias in the data. Using purchasing power parity prices to convert India’s GDP into U.S. dollars avoids this bias.
The difference in the two sets of numbers is astonishingly large and makes a dramatic difference to how we view the balance of economic power over the next 25 years.
At current growth rates and market exchange rates, by 2020, China will have a GDP around a quarter that of the United States.
At current growth rates and PPP exchange rates, by 2020, China’s real GDP will exceed that of the United States.
Per person, China in 2020 will still have a long way to go to catch the United States. But China’s economy will be the world’s largest.
Omissions from GDP. A discussion of omissions from GDP can arouse students’ interest. For example, you might point out that if one of your students mows her/his own lawn, the value of the student’s production doesn’t show up in GDP. But if you hire the student to mow your lawn (and if your student reports the income earned correctly to the IRS), the value of the student’s production does show up in GDP.
Why don’t we measure all lawn mowing as part of GDP? Some reasons are cost of collecting data and the degree of intrusiveness we’d be willing to tolerate. But note how little we spend on collecting the GDP data and how relatively inexpensive it would be to add some questions about domestic production to either the Current Population Survey or the Consumer Expenditure Survey.
The inclusion of the imputed rental of owner-occupied houses, but not owner-used cars and other durables, is a good example.
You might like to explain how the omission of illegal goods and services also leads to some misleading comparisons. For instance, the day before prohibition ended, the production of (illegal) beer was not counted as part of GDP. But the day after prohibition ended, the production of (now legal) beer counted. Ask your students to suggest two good reasons why illegal goods and services are omitted. First, the data are hard (but not impossible) to obtain. Second, there may be the moral position that illegal activities should not be included in GDP. This latter observation can lead to an interesting discussion. Ask the students if they think that the production of, say, marijuana should be included in GDP. Some, maybe even many, of them will see no problem with this. Then ask about the production of murder-for-hire. The response, we hope, will be significantly different. Does such a good have any value?
Classroom activity
Check out At Issue: Should GNNP Replace GDP?
Notes and teaching tips: 5, 9, 10, 27, 34, 40, 44, and 54.
To view a full-screen figure during a class, click the red “expand” button.
To return to the previous slide, click the red “shrink” button.
To advance to the next slide, click anywhere on the full screen figure.
Applying the principles of economics to interpret and understand the news is a major goal of the principles course. You can encourage your students in this activity by using the two features: Reading Between the Lines and Economics in the News.
(1) Before each class, scan the news and select two or three headlines that are relevant to your session today. There is always something that works. Read the headline and ask for comments, interpretation, discussion. Pose questions arising from it that motivate today’s class. At the end of the class, return to the questions and answer them with the tools you’ve been explaining.
(2) Once or twice a semester, set an assignment, for credit, with the following instructions:
(a) Find a news article about an economic topic that you find interesting.
(b) Make a short bullet-list summary of the article.
(c) Write and illustrate with appropriate graphs an economic analysis of the key points in the article.
Use the Reading Between the Lines and Economics in the News features in your textbook as models.
Positive versus normative. Unemployment is an emotionally charged subject and is a good one for reinforcing the important point that economics is positive in contrast to normative. The economist’s job is to try to explain why unemployment exists, what determines its rate, and assess the efficient amount of unemployment.
The benefits of unemployment. It comes as a shock to most students that unemployment has benefits as well as costs and that there is an efficient amount of unemployment that is greater than zero. (Note that this statement is positive!) You might like to spend a bit of class time on this topic. If you do, here are some ideas about what to do:
A good way to introduce the idea that unemployment brings benefits is to think about the unemployment of things rather than people. Look around the campus and notice all the unemployed automobiles in the parking lots/stations. Notice the unemployed class rooms early in the morning and late at night. Notice the unemployed coffee shop seats at peak lecture times. Look around the city and notice all the unemployed automobiles in the car sales lots. Try to make a reservation at any of the hotels in the city and notice that you can almost always get a room—hence, lots of unemployed hotel rooms.
[Continued on the note for the next slide.]
Identifying frictional, structural, and cyclical unemployment. Ask your class if anyone they know has been laid off. Then discuss whether losing a job creates frictional, structural, or cyclical unemployment. Look at your local examples. If you live in a steel-producing area, for example, you can talk about local structural unemployment arising from the closing of a steel manufacturer due to international competition. For cyclical unemployment, ask students how they think the business cycle and cyclical unemployment is related to full-time enrollments at higher education institutions. Students often don’t think there is any relationship. But nationally during a recession, the growth rate of full-time enrollments increases. Ask students if they can explain this relationship. The answer is that during a recession and due to the increase in cyclical unemployment, the opportunity cost of school decreases. This is a great way to keep students thinking about marginal benefits and costs.
Classroom activity
Check out Economics in Action: Cyclical and Structural Unemployment in Michigan
The CPI—an average. It is important for students to understand that the CPI is based on the average expenditure basket, not the expenditure pattern of any given household. Displaying the detailed press releases on the BLS Web site helps make this point very forcibly: students often do not realize until they see the numbers that the CPI must include both costs of owning a house and costs of renting one; costs of buying a car and costs of public transportation; and so on.
Notes and teaching tips: 12, 18, 20, 34, 45, 46, 47, 48, 50, 51, 52, 56, 63, and 64.
To view a full-screen figure during a class, click the red “expand” button.
To return to the previous slide, click the red “shrink” button.
To advance to the next slide, click anywhere on the full screen figure.
Applying the principles of economics to interpret and understand the news is a major goal of the principles course. You can encourage your students in this activity by using the two features: Reading Between the Lines and Economics in the News.
(1) Before each class, scan the news and select two or three headlines that are relevant to your session today. There is always something that works. Read the headline and ask for comments, interpretation, discussion. Pose questions arising from it that motivate today’s class. At the end of the class, return to the questions and answer them with the tools you’ve been explaining.
(2) Once or twice a semester, set an assignment, for credit, with the following instructions:
(a) Find a news article about an economic topic that you find interesting.
(b) Make a short bullet-list summary of the article.
(c) Write and illustrate with appropriate graphs an economic analysis of the key points in the article.
Use the Reading Between the Lines and Economics in the News features in your textbook as models.
Compound Interest You can reinforce the importance of economic growth by relating the fact that if real GDP per person had grown just 0.25 percentage points faster between 1960 and the present, every household today, on average, would have almost $12,000 more income (every person would have $4,500 more). If real GDP per person had grown 1 percentage point faster between 1960 and the present, every household today, on average, would have $50,000 more income (every person would have $21,200 more).To make concrete just how much better off we would have been, get the students to list what they would buy with an extra $21,200 a year.
Classroom activity
Check out Economics in Action: Women Are the Better Borrowers
Classroom activity
Check out Economics in Action: Intellectual Property Rights Propel Growth
Check out Economics in the News: Robots as Skilled Workers
Interactions of sources of growth. Most students can see immediately how investment in physical and human capital in the form of education and training contribute to growth. Some have more difficulty getting a clear view of the role of learning by doing and technological change, particularly the small continuous refinement and improvement to existing technology rather than the spectacular breakthroughs. Much growth probably comes from the interaction of the last two, and this source of growth can be illustrated with a discussion of why firms offer incentives to workers to suggest improvements to working methods and procedures.
Historical development of theories and an aside. The three growth theories studied in this chapter—classical, neoclassical, and new—are presented in historical order. Point out this fact to the students to emphasize and illustrate how economic theory builds on itself. (An aside for you, not your students: Note that the chapter skips the Keynesian era Harrod-Domar model. The main reason for this omission is that these models were quickly shown to be in error and never formed the basis of a seriously proposed growth theory. Based on fixed coefficients and fixed saving rates, the Harrod-Domar model produces either secular stagnation or secular inflation. Neither phenomenon occurs in real economies. Solow’s neoclassical model was developed, historically, to show the error of the Harrod-Domar model, but the neoclassical model also builds naturally on its classical predecessor, and that is the sequence in the textbook.)
Classical theory. Start with the classical theory. The classical theory of growth takes technological change as exogenous, essentially ignores the role of capital (as a result of the era in which it was developed), and assumes that population growth increases when income increases (also as a result of the era in which it was developed). As a result, the conclusions from the classical theory are “dismal” indeed! Some students find it interesting to know that Thomas Malthus, most closely associated with the population part of this theory, was a clergyman, but was also the first person in the Anglophone world to hold the title of Professor of Political Economy (at the East India College). Economists came to realize that capital accumulation and technological change were important parts of the growth process. They also came to understand that population growth does not necessarily increase with income. Hence the stage was set for the neoclassical theory.
Neoclassical theory. Neoclassical theory follows the classical theory by taking technological growth as exogenous. It differs insofar as it assumes that population growth is also exogenous. The major difference is that neoclassical theory stresses the role played by technological change and how it influences saving and capital accumulation. So of the two differences between neoclassical and classical growth theory, the first—the different assumptions about how population growth is determined—reflects an advance in empirical knowledge of the relationship between population growth and income. The second difference—the importance given to technological change, saving, and capital—shows how the neoclassical theory built on the simpler classical model.
New growth theory. Neoclassical theory also is incomplete because the primary engine of economic growth, technology, is exogenous. New growth theory attempts to overcome this weakness. It still uses many of the insights of the neoclassical theory by emphasizing the role of capital accumulation and assuming that population growth is exogenous. But the new growth theory builds on neoclassical theory by examining more closely the role of technology and the factors that influence technological advances.
Giving the students this type of broad overview before presenting the details of the different models is important because it, along with the text’s outstanding overview, allows the students to see the forest as well as the trees. This knowledge not only helps them understand the particular models, but it also helps them gain an appreciation of how economics progresses. (Of course, progress is hardly as steady as the students might believe; for instance, Pigou and Ramsey presented important papers about growth in the early part of the twentieth century, but, nonetheless, progress has been made.)
Achieving faster growth. Policies to promote growth can generate interesting and useful discussion. For example, it is investment that produces growth, and in the previous chapter we showed that investment does not depend on private saving alone. Is it appropriate then to stimulate private saving artificially? Similarly, the arguments for subsidizing research and development and education are both based on public good aspects of those activities, but what form and extent should subsidies take?
Why the Luddites were wrong. This chapter provides you with a wonderful opportunity to explain to your students why the Luddites were wrong—and why the modern neo-Luddite movement is wrong. You can learn more than you need to know about Luddism and the Luddites, ancient and modern, at http://carbon.cudenver.edu/~mryder/itc_data/luddite.html
You might then spend a few minutes agreeing that capital accumulation and technological change decrease the demand for the labor that the new capital replaces. But it increases the demand for other types of labor—complementary labor. People must acquire more skill—some people learn to work with the new capital, some learn how to maintain it in good condition, some learn how to build it, some learn how to market and sell it, some learn to design new ways of using it, some work on thinking up new goods and services to produce with it, and so on. All of these people are more productive that they were before.
New technologies that create new products have even more obvious effects on productivity. The development of the CD in the early 1980s is a good example. Suddenly thousands of people became very productive converting the heritage of recorded music into digital format, cleaning up the sound, and making and selling millions of CDs. The same type of thing is now happening with the DVD and Blu-ray.
Notes and teaching tips: 6, 7, 12, 14, 18, 35, 37, and 50.
To view a full-screen figure during a class, click the red “expand” button.
To return to the previous slide, click the red “shrink” button.
To advance to the next slide, click anywhere on the full screen figure.
Applying the principles of economics to interpret and understand the news is a major goal of the principles course. You can encourage your students in this activity by using the two features: Reading Between the Lines and Economics in the News.
(1) Before each class, scan the news and select two or three headlines that are relevant to your session today. There is always something that works. Read the headline and ask for comments, interpretation, discussion. Pose questions arising from it that motivate today’s class. At the end of the class, return to the questions and answer them with the tools you’ve been explaining.
(2) Once or twice a semester, set an assignment, for credit, with the following instructions:
(a) Find a news article about an economic topic that you find interesting.
(b) Make a short bullet-list summary of the article.
(c) Write and illustrate with appropriate graphs an economic analysis of the key points in the article.
Use the Reading Between the Lines and Economics in the News features in your textbook as models.
Definitions and the meaning of investment in economics. The student has met the key definitions of investment in this chapter, but to be absolutely sure that they are remembered it is worth emphasizing that in economics, “capital” and “investment” without any qualification mean physical capital and purchase of newly produced physical capital goods. Everyday usage of investment as the purchase of stocks or bonds can lead to confusion. So it is worth getting these matters clear right from the start.
A concrete understanding of stock and flow variables is an important building block to understanding economic principles. You can use “buckets” to convey the relationship between stock and flow variables. Buckets are easy to draw along with a simple faucet and hole in the bucket. You can use this illustration to show how the stock changes over time due to the inflow and outflow of material into the bucket. You can extend the use of buckets to any stock/flow concept like wealth or other resources.
Financial Crisis: The fall of 2008 saw the biggest financial crisis since the Great Depression. Essentially securities, such as mortgage-backed securities, lost value and many financial institutions became insolvent. These institutions, such as Fannie Mae, Freddie Mac, Bear Sterns, AIG, and others were considered “too large” to fail. While you cannot fully explain the reasons why failure of a large financial institution might have external costs, your students can readily appreciate the point that if these institutions failed many borrowers would find it significantly more costly to arrange loans. The government acted in most all of these cases by arranging a bailout in one form or another. Some companies were given government loans (AIG received an $85 billion loan from the Fed); others were taken into government oversight (Fannie Mae and Freddie Mac); others were merged into healthier companies, albeit with government assistance (Bear Sterns); a few were allowed to fail (Lehman Brothers).Even beyond these events, most financial institutions were given government assistance in the form of government loans and/or government purchase of stock.
Classroom activity
Check out Economics in Action: The Financial Crisis and the Fix
It is helpful to show explicitly how the market price of a bond is determined by the current interest rate. Using an example of a government bond will be useful for future chapters on monetary and fiscal policy. Explain that a bond is an “IOU” from the issuer and its basic components are its term, face value and coupon payment. For example, a bond might have a $10,000 face value with a coupon payment of $500 for the next 5 years. Point out to your students that this coupon payment means that the bond is essentially paying an interest rate of 5 percent for the next five years…at least as long as its price is $10,000. Explain how the bond can be traded in the secondary market and ask them what they think the bond’s price would be if the market interest rate rose to 6 percent. Make clear that when the interest rate rises to 6 percent, that means that “new” government bonds with a $10,000 face value will sell for $10,000 and will pay a $600 coupon payment. Your students should be able to see that the “old” bond must be worth less than the new bond because the old bond has a smaller coupon payment. Tell your students that while it is possible to determine the precise price for which the old bond will trade, your key point is that the price has fallen from $10,000 to something less. In other words, an increase in the interest rate has lowered the price of (old) bonds!
Real versus nominal interest rate. To drive home the distinction between the nominal interest rate and real interest rate, ask your class if an interest rate of 10 percent is high. Almost assuredly they will respond with a resounding “Yes.” Point out to them that around 1980 a 10 percent interest rate was exceedingly low. At the time a typical interest rate was between 12 percent and 17 percent, depending on the riskiness of the asset and the length of the loan. What accounts for the difference between then and now? The answer is simple: inflation. In 1980 the inflation rate was running at more than 10 percent per year. Given the high inflation rate, the nominal interest rate adjusted so that it, too, was high. Most of the dollars lenders received as (nominal) interest went to keeping their purchasing power intact. But the real interest rate at that time was not much different than the real interest rate nowadays. In other words, the increase in purchasing power received by lenders (the real interest rate) in the 1980s was about the same as the increase in purchasing power received by lenders today.
Take advantage of this model to highlight the effect of the deficit. Whether you draw it on the board or use a laser pointer, track the increase in the real interest rate and the decrease moving along the PDLF curve. Mention that crowding out decreases the capital stock because of the decrease in investment.
Classroom activity
Check out Economics in Action: Greenspan’s Interest Rate Puzzle
Notes and teaching tips: 5, 8, 9, 14, 18, 22, 24, 30, 35, 47, 48, 68, 70, and 71.
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Applying the principles of economics to interpret and understand the news is a major goal of the principles course. You can encourage your students in this activity by using the two features: Reading Between the Lines and Economics in the News.
(1) Before each class, scan the news and select two or three headlines that are relevant to your session today. There is always something that works. Read the headline and ask for comments, interpretation, discussion. Pose questions arising from it that motivate today’s class. At the end of the class, return to the questions and answer them with the tools you’ve been explaining.
(2) Once or twice a semester, set an assignment, for credit, with the following instructions:
(a) Find a news article about an economic topic that you find interesting.
(b) Make a short bullet-list summary of the article.
(c) Write and illustrate with appropriate graphs an economic analysis of the key points in the article.
Use the Reading Between the Lines and Economics in the News features in your textbook as models.
Fiat money. To get across the idea of money, take a colored piece of paper and cut it to the same size as a $20 bill. Then take the paper into class along with a $20 bill. Ask the students why one piece of paper has value and the other does not. Is there anything intrinsically more valuable about the $20 bill? If not, why won’t someone in class exchange his or her old wrinkled piece of Federal Reserve paper with writing on it for the nice new piece you offer?
The contrast between money in economics and money in everyday language. It can be helpful to emphasize that “money” is a technical term in economics that has a precise meaning and that differs from its looser usages in every day language. For example, an economist would not say “Bill Gates makes a lot of money.” Rather, the economist would say “Bill Gates earns a large income.” An interesting exercise is to have students think of statements containing the word “money” that make complete sense in normal language but that misuse the word in its precise economic sense, and to get them to explain why.
A picky point. The textbook is careful in its use of the terms “quantity of money” and “money supply”. The money supply is the relationship between the quantity of money supplied and the interest rate, other things remaining the same. It parallels the demand for money. Although this point might seem picky, you can help your students by using this same language convention. Everyday usage over uses the term “money supply.”
Get the class involved in figuring out what money is. To involve the students in the process of determining what money is, after noting its definition and three functions, ask them what they think should be counted as money. List the suggestions on the board before commenting on them. Coins and currency will certainly be mentioned. Usually each class has a few members who have read the text and will suggest checkable deposits. Almost always you will obtain some not-so-excellent answers, ranging from gold to shares of stock to credit cards. The point of this exercise is to obtain these incorrect answers because they give you a chance to discuss why these items are not money. Without ridiculing the wrong answers, you can poke fun at some of the suggestions. (Point out that students rarely pay for books by giving the bookstore shares of Bombardier stock and asking for change in BCE stock.) By being involved and having to think, the students emerge with a stronger grasp of why money is measured as it is.
Students usually have bank accounts, but often they have never fully thought through what banks do, how they do it, or what the differences are between banks and other deposit-taking institutions, so what tends to strike instructors as rather dry descriptive material can be interesting to students. It is worth being explicit about the fact, which students tend to be very aware of, that in practice chartered banks earn income not only by the spread between their deposit and lending rates, but also by charging fees for their services. The text focuses on the role of depository institutions as a source of credit creation; for most students, like most customers, their most important function is actually facilitating the payment process, and a little discussion on that (and how relatively cheap it is) can also engage students.
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Check out At Issue: The Volcker Rule
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Check out Economics in Action: The Fed’s Balance Sheet Explodes
Check out Economics in the News: A Massive Open Market Operation
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Check out Economics in Action: The Variable Money Multipliers
It is worth reminding students that “money” has a jargon sense in economics; students are often confused by the phrase “demand for money” and it is worth tackling it head-on by emphasizing this does not equate to “wanting to be rich,” but refers to how much of total wealth (assets) the public want to hold in the particular form “money.” Students often try to understand ideas in terms of their own lives; few will make a clear connection between interest rates and demand for money from their own introspection. There are two ways to overcome this: one is to ask them to think in terms of extreme situations (get what short-term interest rates are in a high-inflation country); the other is to get them to imagine themselves in the job of treasurer of a corporation with large liquid resources, and to think how their behavior with respect to those funds might differ according to the short-term interest rates available.
Velocity of circulation. Emphasize that velocity is defined by the equation V = PY/M, and is not the average number of times a given piece of paper changes hands in a year. Nor is V the transactions velocity because most transactions are not payments for goods and services. (Transactions are twice PY because they also include payments for the services of factors of production, which equals PY, plus all the purely financial transactions such as buying and selling stocks, bonds, foreign currency, and real estate.)
The quantity theory of money. Given that V is defined as PY/M, the equation of exchange, MV = PY is an identity. The quantity theory is not the equation of exchange but the propositions that (1) V is independent of M and (2) Y equals potential GDP, which is independent of M. Given these assumptions, the inflation rate equals the growth rate of the quantity of money.
The quantity theory of hyperinflation. A possible exercise is to ask students whether we would expect the correlation between money growth and inflation to remain strong in a hyperinflation. Most will see that in a hyperinflation, velocity will increase. Emphasize that the level of velocity is greater in hyperinflation but if the inflation rate remains constant (and high) velocity also is constant (and high), so the quantity theory still holds. It does not hold in the move from low inflation to high inflation. The inflation rate overshoots the growth rate of the quantity of money.
Classroom activity
Check out Economics in Action: Does the Quantity Theory Work?
A money creation experiment. The process through which banks “create money” can be a dark and mysterious secret to the students. Indeed, even though the text contains a superb description of the process, students still manage to end up confused. The first prerequisite to students understanding the process is that they be comfortable with balance sheets shown in the form of T-accounts, and it is well worth spending time on them to make sure students understand what they are and what they show. This will be the first time some students have ever had to interpret a balance sheet, and it is key that they understand that assets are what are owned, liabilities are what are owed, by the institution for which the balance sheet is constructed; and that the two sides must balance.
Mark Rush (our U.S. study guide author and supplements czar) tackles the problem of getting students to understand bank money creation head-on by (again) involving the class in a demonstration. Prepare by decorating a piece of green paper with currency-like symbols. (For instance, Mark draws a seal and around it writes “In Rush We Trust.” You may write the same slogan, but substituting your name for his probably will be more effective; an alternative is to use “play money”). Label this piece of paper a “$100 bill.” In class use one of the students by handing him the bill. Tell him that he has decided to deposit it in his bank and ask him his bank’s name. On the chalkboard draw a balance sheet for the bank with deposits of $100, reserves of $10, and loans of $90. Tell the students that the required reserve ratio is 10 percent, so this bank currently has no excess reserves. Now, instruct the student to deposit the money in his bank, which coincidentally happens to be run by the student next to him. Show the class what happens to the balance sheet and how the bank now has excess reserves of $90. Clearly the “banker” will loan these reserves to the next student in the class, who wants a $90 dollar loan so she can take a bus ride to some nearby dismal location. (Being located in Gainesville, Florida, Mark picks on the city of Stark, home to Florida’s electric chair and a town with an apt name.) When the loan takes place, rip the $100 bill so that only about nine tenths of it is given as the loan. This student pays the money to Greyhound—coincidentally the next student. Ask the name of Greyhound’s bank and draw an initial balance sheet for this bank identical to the initial balance sheet of the first bank. Greyhound deposits the money in the bank—the next student in the row. Work with the balance sheets to show what happens to the first bank and what happens to the second bank. Clearly the first one no longer has excess reserves but the second bank now has $81 of excess reserves ($90 of additional deposits minus $9 of required reserves). The second bank will make a loan, which you can act out with more students in the class, again ripping off nine tenths of the remaining bill. Work through the point where the second loan winds up deposited in a third bank and then stop to take stock. At this point the quantity of money has increased by $90 in the second bank and $81 in the third, for a total increase—so far—of $171. The students will clearly see that this loaning and reloaning process is not yet over and that the quantity of money will increase by still more. Moreover (and more important) the students will grasp how banks “create money.”
Notes and teaching tips: 5, 6, 8, 35, 37, 38, 49, 50, 51, 56, and 59.
To view a full-screen figure during a class, click the red “expand” button.
To return to the previous slide, click the red “shrink” button.
To advance to the next slide, click anywhere on the full screen figure.
Applying the principles of economics to interpret and understand the news is a major goal of the principles course. You can encourage your students in this activity by using the two features: Reading Between the Lines and Economics in the News.
(1) Before each class, scan the news and select two or three headlines that are relevant to your session today. There is always something that works. Read the headline and ask for comments, interpretation, discussion. Pose questions arising from it that motivate today’s class. At the end of the class, return to the questions and answer them with the tools you’ve been explaining.
(2) Once or twice a semester, set an assignment, for credit, with the following instructions:
(a) Find a news article about an economic topic that you find interesting.
(b) Make a short bullet-list summary of the article.
(c) Write and illustrate with appropriate graphs an economic analysis of the key points in the article.
Use the Reading Between the Lines and Economics in the News features in your textbook as models.
Exchange rates: Exchange rates are always somewhat confusing. The problem is that there are two ways to express an exchange rate: It can be expressed as the units of foreign currency per U.S. dollar (120 yen per U.S. dollar) or as U.S. dollars per unit of foreign currency (1.28 U.S. dollars per Euro). Tell this fact to the students. But, because the textbook is consistent in using the exchange rate as the units of foreign currency per U.S. dollar, stick to the “120 yen per dollar” format in your lectures.
Classroom activity
Check out Economics in Action: The Dollar on a Roller Coaster
Interest Rate Parity. Be sure that your students appreciate interest rate parity. There are many horror stories of people losing their shirts by misunderstanding interest rate parity.
One story concerns the once wealthy Catholic Church of Australia that decided to borrow in Japan at a low interest rate and lend the proceeds of its borrowing in Australia at higher interest rates. When the Australian dollar nosedived against the Japanese yen, the church struggled to repay its loans.
Interest rate parity always holds. Interest rates might look unequal, but the market expectation of the change in the exchange rate equals the gap between interest rates. It is a foolish person (or organization) that acts as if it can beat the market.
Purchasing Power Parity. You can easily get your students to test purchasing power parity. Have them check the prices of some well-known titles at amazon.com, amazon.ca, and amazon.co.uk,. Get the latest exchange rate for the U.S. dollar against the Canadian dollar and the U.K. pound, and see whether it is cheaper to buy a given title in the United States, Canada, or the United Kingdom.
If one U.S. dollar exchanges for 1.33 Canadian dollars, then purchasing power parity is attained when one U.S. dollar buys the same quantity of goods and services in the United States as 1.33 Canadian dollars buys in Canada.
If one U.S. dollar buys more goods and services in the United States than 1.33 Canadian dollars buy in Canada, people will expect that the U.S. dollar will eventually appreciate.
Similarly, if one U.S. dollar buys less goods and services in the United States than 1.33 Canadian dollars buy in Canada, people will expect that the U.S. dollar will eventually depreciate.
The Economist reports a Big Mac Index that uses the prices of McDonald’s Big Macs and purchasing power parity to make predictions about exchange rate movements. The index is somewhat tongue-in-cheek as it would be hard to arbitrage differences in Big Mac prices by taking a Big Mac on a plane from, say, Japan to the United States. However, it is easier to arbitrage the inputs into Big Macs such as beef. Thus, one might still expect some convergence of Big Mac prices over time. The Economist claims some success in its exchange rate predictions.
Classroom activity
Check out Economics in Action: The People’s Bank of China in the Foreign Exchange Market
Classroom activity
Check out Economics in Action: Three Decades of Deficits
The analogy of a country being like an individual in being a borrower or lender is revealing. When Polonius tells Laertes to “neither a lender nor a borrower be” in Hamlet, he is the voice of prudence. But, perhaps, it is too much prudence. Much economic activity and development would be impossible without borrowing and lending. This is true at the individual level and for countries. The United States financed its industrialization and railroads in the nineteenth century by being a debtor nation.