33  Common screw-ups

The 17 things students confuse. Read this before the exam.

CPI overestimates inflation, IGDPDI underestimates. CPI uses base-year quantities (Laspeyres), so it ignores substitution. IGDPDI uses current-year quantities and base-year prices (Paasche), so it does the opposite. Reverse for deflation.

Natural rate of unemployment is not zero. It is frictional + structural, often pegged at \approx 4\%. Cyclical is the part that disappears in expansions.

Aggregate output equals aggregate income identically. Total value of goods produced = total factor payments. Both are Y.

Actual investment equals planned investment only at equilibrium. Off-equilibrium: I_{actual} = I_{planned} + \Delta\text{unplanned inventory}. If Y > AE^d, inventory builds up.

Paradox of thrift. More saving (lower \overline{C_0}) lowers Y^*. Total saving stays the same because S = I^d at equilibrium and I^d didn’t change.

Tax multiplier is negative. K_T = -c/(1-c). Cutting taxes raises Y^*, raising taxes lowers Y^*.

Balanced-budget multiplier is 1, not 0. Raise both G and T by $100. Deficit unchanged. Y^* rises by exactly $100. The K_G effect outweighs the K_T effect by exactly 1.

Real-world multiplier is roughly 1.4, not 4. The textbook formula assumes no leakages other than saving. Income-conditional taxes, imports, monetary offset, and crowding-out shrink it.

Federal debt is a stock. Federal deficit is a flow. They are not the same number.

Banks want excess reserves at zero. ER earns nothing. Banks make loans until ER = 0. The lending creates new deposits. That is how money is created.

The Fed changes M^S directly. The interest rate r^* adjusts via the bond market: \uparrow M^S \Rightarrow excess money \Rightarrow people buy bonds \Rightarrow bond prices rise \Rightarrow yields fall.

Bond price and r are inverse. Always. A 7% bond becomes worth less when new bonds pay 8%.

Three motives for money demand. Transactions, precautionary, speculative. Y shifts the curve through transactions. r moves along the curve through speculative.

Imports are a debit on the current account. They use up foreign exchange. Exports are a credit. They generate it.

Capital account: U.S. resident buying a foreign asset is a debit. Foreigner buying a U.S. asset is a credit. Watch the direction of the asset, not the direction of the cash.

Currency appreciation lowers exports, doesn’t raise them. Stronger currency makes home goods more expensive abroad.

Under fixed exchange rates, monetary policy loses its FX channel. Only the interest-rate channel operates, partially. This is why countries with fixed rates lose monetary independence.