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ECON 2305 semester notes

by: Ariana Rios-Lobo

ECON 2305 semester notes ECON 2305

Marketplace > University of Houston > Economcs > ECON 2305 > ECON 2305 semester notes
Ariana Rios-Lobo
GPA 3.25

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These are all of the notes I took for macro last semester
Macroeconomic Principles
Sergiy Kasyanenko
Econ, Marco, Macroeconomics, Economics
75 ?




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This 18 page Bundle was uploaded by Ariana Rios-Lobo on Saturday January 23, 2016. The Bundle belongs to ECON 2305 at University of Houston taught by Sergiy Kasyanenko in Fall 2015. Since its upload, it has received 49 views. For similar materials see Macroeconomic Principles in Economcs at University of Houston.


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Date Created: 01/23/16
Saving and Investing Financial Institutions The Financial System  the group of institutions that helps match the saving of one person with the investment of another. Financial Markets  institutions through which savers can directly provide funds to borrowers. Examples: o The bond market. o A bond is a certificate of indebtedness. o The stock market. o A stock is a claim to partial ownership in a firm. Financial Intermediaries:  institutions through which savers can indirectly provide funds to borrowers.  Examples: o Banks  Mutual funds o institutions that sell shares to the public and use the proceeds to buy portfolios of stocks and bonds Different Kinds of Saving Private Saving  The portion of households’ income that is not used for consumption or paying taxes o = Y – T – C Public Saving  Tax revenue less government spending o = T – G National saving  private saving + public saving  = (Y – T – C) + (T – G)  = Y – C – G  the portion of national income that is not used for consumption or government purchases Saving and Investment  Recall the national income accounting identity: Y = C + I + G + NX  Focus on the closed economy case: Y = C + I + G  Solve for I: I = Y – C – G  = (Y – T – C) + (T – G)  Saving = investment in a closed economy Budget Deficits and Surpluses Budget surplus  an excess of tax revenue over govt spending  = T – G = public saving  Budget deficit  a shortfall of tax revenue from govt spending  = G – T  –(public saving) The Meaning of Saving and Investment Private Saving  is the income remaining after households pay their taxes and pay for consumption.  Examples of what households do with saving: o Buy corporate bonds or equities o Purchase a certificate of deposit at the bank o Buy shares of a mutual fund o Let accumulate in saving or checking accounts Investment  is the purchase of new capital.  Examples of investment: o General Motors spends $250 million to build a new factory in Flint, Michigan. o You buy $5000 worth of computer equipment for your business. o Your parents spend $300,000 to have a new house built. o Remember: In economics, investment is NOT the purchase of stocks and bonds! The Market for Loanable Funds A supply–demand model of the financial system  Helps us understand: o How the financial system coordinates saving & investment. o How govt policies and other factors affect saving, investment, the interest rate.  All savers deposit their saving in this market.  All borrowers take out loans from this market.  There is one interest rate, which is both the return to saving and the cost of borrowing. The supply of loanable funds comes from saving: o Households with extra income can loan it out and earn interest. o Public saving, if positive, adds to national saving and the supply of loanable funds. o If negative, it reduces national saving and the supply of loanable funds.  An increase in the interest rate o makes saving more attractive, which increases the quantity of loanable funds supplied. Unemployment Labor Force Statistics Employed: paid employees, self-employed, and unpaid workers in a family business Unemployed: people not working who have looked for work during previous 4 weeks Not in the labor force: every one else Labor force: total number of workers, including the employed and unemployed Unemployment rate: 100(# of unemployed/ labor force)  Not a perfect indicator of joblessness or the health of the labor market  Excludes discouraged workers  Does not distinguish between full-time and part-time jobs not available  Some people misreport their work status  Still very useful barometer of the labor market and economy Labor force participation rate: 100(labor force/ adult population) Discouraged workers: would like to work but have given up looking for jobs. Not in labor force Natural rate of unemployment -the normal rate of unemployment around which the actual unemployment rate fluctuates Frictional unemployment:  Occurs when workers spend time searching for the jobs that best suit their skills and tastes  Short-term for most workers Structural unemployment: Occurs when there are fewer jobs than workers   Usually longer-term Job Search: the process of matching workers with appropriate jobs Sectoral shifts: changes in the compositions of demand across industries or regions of the country  Such shifts displace some workers, who must search for new jobs appropriate for their skills and tastes Cyclical unemployment -the deviation of unemployment from its natural rate -associated with business cycles Public Policy and Job Search  Govt. employment agencies: o Provide information about job vacancies of speed up the matching of workers with jobs  Public training programs: o Aim to equip workers displaced from declining industries with the skills needed in growing industries Unemployment insurance (UI): a govt. program that partially protects workers' income when they become unemployed  UI increases frictional unemployment (people respond to incentives) Benefits of UI:  Reduces uncertainty over incomes  Gives the unemployment more time to search, resulting in better job matches and this higher productivity Structural unemployment 1. Minimum-Wage Laws o The min. wage may exceed the eq'm wage for the least skilled or experienced workers, causing structural unemployment o Small part of labor force, so it does not explain most unemployment 2. Unions: a worker association that bargains with employers over wager, benefits, and working conditions o Unions exert their market power to negotiate higher wages for workers o Typical union worker ears 20% higher wages and gets more benefits than nonunion worker o When unions raise the wage eq'm quantity of labor demands falls and unmployment results o Insiders: workers who remain employed, better off o Outsiders: workers who lose their jobs, worse off o Some outsiders go to non-union labor markets, which increases labor supply and reduces wages in those markets 3. Efficiency Wages o Theory: firms voluntarily pay above-equilibrium to boost worker productivity Reasons why firms might pay efficiency wages 1. Worker health  In less developed countries, poor nutrition is a common problem. Paying higher wages allows workers to eat better, makes them healthier, more productive 2. Worker turnover  Hiring and training new workers is costly.  Paying high wages gives workers more incentive to stay, reduces turnover 3. Worker quality  Offering higher wages attracts better job applicants, increases quality of the firm's workforce 4. Worker effort  Workers can work hard or shirk  Workers have more incentive to work not shirk if market wage above eq'm wage  Monetary System Why money is important Barter: the exchange of one good or service for another -without money, trade would require barter Double coincidence of wants: the unlikely occurrence that two people each have a good the other wants -Every transaction would require a double coincidence of wants Most people would have to spend time searching for others to trade with, huge waste of resource Money: the set of assets that people regularly use to buy goods and services form other people -This searching is unnecessary with money Three Functions of Money Medium of exchange: an item buyers give to sellers when they want to purchase good and services Unit of account: the yardstick people use to post prices and record debts Store of value: an item people can use to transfer purchasing power from the present to the future 2 kinds of money Commodity money: takes the form of a commodity with intrinsic value Ex. Gold coins, cigarettes of POW camps Fiat money: money without intrinsic value, used as money because of govt. decree Ex. The US dollar The Money Supply Money supply: the quantity of money available in the economy  Currency: the paper bills ad coins in the hands of the public  Demand deposits: balances in bank accounts that depositors can access on demand by writing a check M1: currency, demand deposits, traveler's checks, and other checkable deposits M1: $3.0 trillion (Sep. 2015) M2: everything in M1 plus saving deposits, small time deposits, money market mutual funds, and a few minor categories M2: $12.1 trillion (Sep. 2015) Central Banks and Monetary Policy Central bank: an initiation that oversees the banking system and regulates the money supply Monetary policy: the setting of the money supply by policymakers in the central bank Federal Reserve (Fed): the central bank of the U.S  Board of Governors  12 regional Fed banks  Federal Open Market Committee (FOMC): decides monetary policy Bank Reserves In fractional reserve banking system, banks keep a fraction of deposits as reserves and use the rest to make loans The Fed. established reserve requirements, regulations on the minimum amount of reserves that banks must hold against deposits Banks may hold more than this minimum amount if they choose The reserve ration, R = fraction of deposits that banks hold as reserves = total reserves as a percentage of total deposits Bank T-Account T-account: a simplified accounting statement that shows a banks assets and liability Banks' liabilities include deposits, assets include loans and reserves look at cases in PowerPoint Money multiplier: the amount of money the banking system generates with each dollar of reserves = 1/R Money supply= money multiplier* banks reserves Assets: besides reserves and loans, banks also hold securities Liabilities: besides deposits, banks also obtain funds from issuing debt and equity Bank capital: the resources a bank obtains by issuing equity to its owners  Bank assets- bank liabilities= bank capital Leverage: the use of borrowed funds to supplement existing funds for investment purposes Leverage ratio: the ration of assets to bank capital Capital requirement: a govt. regulation that specifies a minimum amount of capital, intended to ensure banks will be able to pay off depositors and debts How the Fed Influences Reserves Open- Market Operations (OMOs): the purchase and sale of U.S. government bonds by the Fed.  To decrease bank reserves and the money supply the Fed. Sells govt. bonds  To increase bank reserves and the money supply the Fed. Buys govt. bonds Discount rate: the interest rate on loans the Fed makes to banks  Traditional method: adjusting discount rate to influence the amount of reserves banks borrow  New method: Term Auction Facility: the Fed chooses the quantity of reserves it will loan, then banks bid against each other for these loans The Fed sets reserve requirement: regulations on the minimum amount of reserves banks must hold against deposits  Reducing reserve requirements would lower the reserve ration and increase the money multiplier Fed has paid interest on reserves banks keep in accounts at the Fed,  Raising the interest rate would increase the reserve ratio and lower the money multiplier Money Growth and Inflation Inflation: the increase in the overall level of prices Hyperinflation: an extraordinary high rate of inflation The Classical Theory of Inflation Overall price levels: 1. The price level as the price of a basket of goods and services 2. The price level as a measure of the value of money a. A rise in the price level means a lower value of money because each dollar in your wallet now buys a smaller quantity of goods and services P: price of goods and services measured in terms of money 1/P: the value of money measured in terms of goods and services  The quantity of goods and services that can be bought with $1 equals 1/P o When the overall price level P rises, the value of money falls Money supply, Money Demand, and Monetary Equilibrium Money Supply: the quantity of money supplied controlled by the Fed Money Demand: how much wealth people want to hold in liquid form  people hold money because it is the medium of exchange  A higher price level increases the quantity of money demand Real vs. Nominal Variables Nominal variables: measured in monetary units Ex. Nominal GDP Nominal interest rate Nominal wage Real variables: measures in physical units Ex. Real GDP Real interest rate Real wage Relative Price: the price of one good relative to (divided by) another  Measures in real units, so they are real variables W= nominal wage= price of labor… %15/ hour P= price level= price of g&s… $5/ unit of output Real wage: the price of labor relative to the price of output W/P= $15/$5= 3units output per hour The classical dichotomy Classical dichotomy: the theoretical separation of nominal and real variables The Neutrality of money Monetary neutrality: the proposition that changes in the money supply so not affect real variables  Relative price is unchanged when money is doubled  The real wage W/P remain unchanged o Classical dichotomy and neutrality of money describes the economy in the long run o Monetary changes can have important short-run effects on real variables The Velocity of Money Velocity of money: the rate at which money changes hands P x Y = nominal GDP = (price level) x (real GDP) M= money supply V= velocity V= (P x Y)/M  V tends to be constant The Quantity Equation Multiply both sides by M M x V = P x Y 1. V is stable 2. Change in M causes nominal GDP to change by the same percentage 3. A change in M does NOT affect Y: money is neutral a. Y is determined by technology and resources 4. So, P changes by same percentage as P x Y and M 5. Rapid money supply growth causes rapid inflation o Economic growth increase # of transactions o Some money growth is needed for these extra transactions o Excessive money growth causes inflation Hyperinflation o Generally inflation exceeding 50% per month Recall: Prices rise when the govt. prints too much money o Excessive growth in the money supply always causes hyperinflation The Inflation tax o when revenue is inadequate and ability yo borrow is limited, govt. may print money to pay for its spending o Almost all hyperinflation starts this way Inflation tax: printing money causes inflation, which is like a tax on everyone who hold money The Fisher Effect The fisher Effect: when Fed increases the rate of money growth, the long-run result is both a higher inflation rate and a higher nominal interest rate Nominal interest rate= Inflation rate +c Real interest rate The inflation fallacy: most people think inflation erodes real income  But inflation is a general increase in prices of the things people buy Shoeleather costs: the resources wasted when inflation encourages people to reduce their money holdings  Incudes the time and transactions costs of more frequent bank withdraws Menu costs: the costs of changing prices  Printing new menus, mailing new catalogs Misallocation of resources from relative-price variability: firms don’t all raise prices at the same time, so relative prices can vary… which distorts the allocation of resources Confusions and inconvenience: inflation changes the yardstick we use to measure transactions.  Complicated long-range planning and the comparison of dollar amounts over time Tax distortions: inflation make nominal income grow faster than real income Arbitrary redistribution of wealth:  Higher-than-expected inflation transfers purchasing power from creditors to debtors: debtors get to repay their debt with dollars that aren't worth as much  Lower-than-expected inflation transfers purchasing power from debtors to creditors High inflation is more variable  Open Economy Closed economy: does not interact with other economies in the world Open economy: interacts freely with other economies in the world The flow of Goods and Services Exports: domestically- produced goods and services sold abroad Imports: foreign- produces goods and services sold domestically Net Exports (NX) or trade balance= value of exports- value of imports Variables that influence Net exports:  Consumers' preference for foreign and domestic goods  Prices of goods at home and abroad  Income of consumers at home and abroad  The exchange rates at which currency trades for domestic currency  Transportation costs  Govt. policies NX measures the imbalance in a country's trade in goods and services Trade deficit: an excess of imports over exports (NX < 0) Trade surplus: an excess of exports over imports (NX > 0) Balanced trade: when exports = imports (NX = 0) The flow of capital Net capital outflow (NCO): domestic residents' purchases of foreign assets Minus foreigners' purchases of domestic assets NCO is also called net foreign investment When NCO > 0 "capital outflow"  Domestic purchases of foreign assets exceed foreign purchases of domestic assets When NCO < 0 "capital inflow"  Foreign purchases of domestic assets exceed domestic purchases of foreign assets Variables that influence NCO  Real interest rates paid on foreign assets  Real interest rates paid on domestic assets  Perceived risks of holding foreign assets  Govt. policies affecting foreign ownership of domestic assets The accounting identity An accounting identity: NCO = NX  Arises because every transaction that affects NX also affects NCO by the same amount (vice versa) When a foreigner purchases a good from the US  US exports and NX increases  The foreigner pays with currency or assets, so the US acquires some foreign assets, causing NCO to rise When a US citizen buys foreign goods  US imports rise, NX falls  The US buyer pays with US dollars or assets, so the other country acquires US assets, causing US NCO to fall Saving, investment, and international flows of goods and assets Y = C + I + G + NX accounting identity Y - C - G = I + NX rearranging terms S = I + NX since S = Y - C -G S = I + NCO since NX = NCO When S > I, the excess loanable funds flow abroad in the form of positive net capital outflow When S < I, foreigners are financing some of the country's investment, and NCO < 0 The Nominal Exchange Rate Nominal exchange rate: the rate at which one country's currency trades for another Express all exchange rates as foreign currency per unit of domestic currency Appreciation: an increase in the value of a currency as measured by the amount of foreign currency it can buy Depreciation: a decrease in the value of a currency as measured by the amount of foreign currency it can buy The Real Exchange rate Real exchange rate: the rate which the goods and services of one country trade for the goods and services in another county Real exchange rate= (e x P)/P* P= domestic price P* = foreign price (in foreign currency) e = nominal exchange rate (foreign currency per unit of domestic currency The Real Exchange rate with Many Goods P= U.S price level P*= foreign price level Real exchange rate= price of a domestic basket of goods relative to price of a foreign basket of goods o If US real exchange rate appreciates. US good become more expensive relative to foreign goods Law of on price: the notion that a good should sell for the same price in all markets Arbitrage: making profit buy buying cheap and selling somewhere where it's more  expensive Purchasing-power parity (PPP): a theory of exchange rates whereby a unit of any currency should be able to buy the same quantity of goods in all countries According to PPP: e x P = P* So e= P*/P PPP and its Implications  PPP implies that the nominal exchange rate between two countries should equal the ration of price level  If the two counties have different inflation rates, the e will change over time o If inflation higher in Mexico than in US… P* rises faster than P so e rises… dollar appreciates against the peso o If inflation higher in US than in Japan… P rises faster than P* so e falls… dollar depreciates against yen Limitations of PPP Theory Why exchange rates do NOT always adjust to equalize prices across countries  Many goods cannot easily be traded o Haircuts, movies  Foreign, domestic goods not prefect substitutes o Some US consumers prefer Toyotas over Chevys o Price difference reflect taste differences  PPP works in many cases especially as an explanation of long-run trends  The greater a countries inflation rate, the faster its currency should depreciate o Data supports prediction Theory of the Open Economy The market of loanable funds S= I + NCO NCO > 0 … S > I NCO < 0… S < I Supply of loanable funds= saving  A dollar saving can be used to finance o The purchase of domestic capital o The purchase of a foreign asset So demand for loanable funds= I + NCO Recall: S depends positively on the real interest rate, r I depends negatively on r. NCO depends negatively on r The market for the foreign-currency exchange NCO = NX In the market for foreign-currency exchange NX is the demand for dollars: Foreigners need dollars to buy US net exports Trade policy: a govt. policy that directly influences the quantity of goods and services that a country imports or exports Tariff- a tax on imports Import quota- a limit on the quantity of imports "voluntary exports restrictions"- the govt. pressures The Short-Run Tradeoff Between Inflation and Unemployment (hardest chapter for me) CH. 22 In the long run inflation and unemployment are unrelated Inflation rate depends mainly on growth in the money supply Phillips curve: shows the short-run trade-off between inflation and unemployment A. Low agg demand, low inflation, high u-rate B. High agg demand, high inflation, low u-rate Policy Menu from PC:  Low unemployment with high inflation  Low inflation with high unemployment  Anything in between The Vertical Long- Run Phillips Curve 1968: Milton Friedman and Edmund Phelps argues that the tradeoff was temporary Natural -rate hypotheses: the claim that unemployment eventually returns to its normal of "natural" rate, regardless of the inflation rate unemployment rate= natural rate of unemployment - a(Actual inflation - expect inflation) Short run: Fed can reduce u-rate below the natural u-rate by making inflation greater than expected Long run: expectation catch up Supply shock: an event that directly alters firms' costs and prices, shifting the AS and PC curves Ex. Larges change in oil prices The Cost of Reducing Inflation Disinflation: a reduction in the inflation rate To reduce inflation, Fed must slow the rate of money growth, which reduces agg demand Disinflation requires a period of high unemployment and low output Sacrifice ratio: percentage points of annual output lost per 1 percentage point reduction in inflation Typical estimate of the sacrifice ratio: 5 To reduce inflation rate 1%, must sacrifice 5% of a year's output Can spread cost over time.. To reduce inflation by 6% can either:  Sacrifice 30% of GDP for one year  Sacrifice 105 of GDP for three years MY ADVICE TO YOU: - make flash cards for all the definitions and formulas! - KNOW THE FORMULAS - The second exam is the easiest - If you know the definitions you’ll know how to apply them


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