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BUNDLE for Exam 2

by: Sydney King

BUNDLE for Exam 2 Econ201

Sydney King

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These notes cover what will be in EXAM 2 Chapters 13, 16-19
Principles of Macroeconomics
Naveen Sarna
Economics, Macro
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This 12 page Bundle was uploaded by Sydney King on Wednesday April 13, 2016. The Bundle belongs to Econ201 at University of Maryland taught by Naveen Sarna in Spring 2016. Since its upload, it has received 208 views. For similar materials see Principles of Macroeconomics in Economcs at University of Maryland.


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Date Created: 04/13/16
Chapter 13: Saving, Investment, and the Financial System 1. Financial Markets- institutions through which a person who wants to save can directly supply funds to one who wants to borrow.  Bond Market- a bond is a certificate of indebtedness that specifies the obligations of the borrower to the holder of the bond. ( Bond serves as an IOU, identifies time when loan will be repaid(date of maturity, rate of interest that will be paid until loan matures.)  Credit risk- probability that a borrower will fail to pay some of the interest or principal, failure to pay is known as a default  Tax treatment- way tax laws treat interest earned on the bond ( bonds issued by state and local govts pay lower interest than bonds issued by corps. Or federal govt  Stock Market- represents ownership in firm and claim to profits that firm makes , offer the holder higher risk and higher return ( sale of stock to raise money is called equity finance and sale of bonds is called debt finance)  When people become optimistic about a company’s future, they raise demand for the stock  Stock Index- computed as an avg of group of stock prices (ex. Dow Jones)  Financial Intermediaries- institutions where savers can indirectly provide funds to borrowers - Banks- take in deposits from people who want to save and use deposits to make loans for those who want to borrow, also facilitate purchases of goods and services by allowing people to write checks against their deposits and access deposits with debit cards. - Mutual Funds- sells shares to public and uses proceeds to buy a selection/portfolio of different types of stocks, bonds, or both . Shareholder accepts all the risks and returns, if value rises then shareholder benefits, if it falls shareholder suffers the loss. 2. Important Identities  Y= C+I+G+NX  Closed Economy- doesn’t interact with other economies, no engagement in trading goods and services, or intl borrowing and lending. - imports and exports are zero, NX=0 so Y=C+I+G - Y-C-G=I total income in economy that remains after paying for C+G also known as NATIONAL SAVING, denoted as S so S=I - S= (Y-T-C)+ (T-G), both T’s cancel out, separates national saving into two pieces, private and public Chapter 13: Saving, Investment, and the Financial System  Open Economies- interact w/ other economies around the world  Private saving- amount of income that households have left after paying their taxes and paying for their consumption. (Y-T-C)  Public Saving- amount of tax revenue govt has left after paying for its spending. (T-G)  Budget Surplus- if T exceeds G, receiving more money than it spends.  Budget Defecit- (T-G) is a negative number 3. The Market for Loanable Funds  Savers go to this market to deposit their saving  Borrowers go to take out their loans  One interest rate which is both the return to saving and cost of borrowing 4. Supply and Demand for Loanable Funds  Supply comes from people who have extra income they want to save and lend out, saving is the source of supply  Demand comes from households and firms who wish to borrow to make investments (ex. taking out mortgages to buy new homes, borrowing equip to build factories). Investment is the source of demand.  Interest Rate is the price of the loan. Shows amount borrowers pay for loans and amount lenders receive on their saving  Higher IR- borrowing is more expensive, quantity of LF of demand falls  Policy 1: Tax incentives for saving increase supply of loanable funds. Reduced quililbrium IR, raises equilibrium quantity of loanable funds  Policy 2: Investment Incentives increase demand for loanable funds, raises equilibrium interest rate, raises quilibrium quantity of loanable funds.  Policy 3: Budget Deficit decreases supply of loanable funds, raises equilibrium IR, reduces, equilibrium quantity of loanable funds.  Crowding out- fall in investment due to govt borrowing to finance budget deficit, it crowds out private borrowers who are trying to finance investment. Chapter 16: The Monetary System 1. The Meaning of Money  Money- set of assets in the economy that people use to buy goods/services from each other  Money has three functions (Medium of exchange, unit of account, store of value)  Medium of exchange- item buyers give to sellers when buying goods and services  Unit of account- used when people want to measure and record economic value  Store of value- money is transferable from present to future.  Liquidity- how easily money can transfer to cash 2. The Kinds of Money  Commodity – takes form of a commodity but has intrinsic value, meaning it has value if not used as money. (ex. Gold – used in industry and for making jewelry)  Fiat- money without intrinsic value, est. as money by government decree 3. Money in the U.S. Economy  Money Stock-quantity of money circulating in the economy  Currency-paper bills and coins in the hands of the public (most widely accepted medium of exchange)  Demand deposits- balances in bank accounts where depositors can access demand by writing a check or swiping a debit card  M1- holds demand deposits, travelers checks, checkable deposits, currency  M2-savings deposits, small time deposits, money market mutual funds, everything in M1 4. Federal Reserve System  Fed- example of central bank and serves as an institution to oversee the banking system and regulate quantity of money in the economy.  2 related jobs- 1. regulate banks/ensure health of banking system and acts as a bank’s bank( Fed makes loans to banks when banks want to borrow) 2. Control the money supply  FOMC(Federal Open Market Committee)- controls money supply, contains 7 members of board of governors and 5/12 regional bank presidents  Primary tool- OMO(Open Market Operations)- purchase and sale of US govt bonds ( Buy Bonds- INCREASE Money Supply , Sell Bonds- DECREASE Money Supply) 5. Banking  Reserves- deposits that banks have received but not loaned out Chapter 16: The Monetary System  T-account- shows banks assets and liabilities  Fractional reserve banking- bank only keeps a fraction of its deposits in reserves  Reserve ratio- fraction of total deposits banks holds as reserve  Reserve requirement- what Fed sets as minimum amount of reserves banks must hold  Excess reserves- what banks hold as reserves above minimum 6. The Money Multiplier  Money Multiplier- amount of money banking system generates with each dollar of reserves, it is the reciprocal of the reserve ratio ( 1/R)  The higher the reserve ratio, less of each deposit banks loan out, smaller the money multiplier  In a more realistic world, banks get financial resources not just from accepting deposits but also from issuing equity and debt.  Bank Capital-resources that bank obtains from issuing equity to owners  Reserves, loans, and securities on left side of balance sheet must always equal deposits, debt, and capital on the right side of the balance sheet.  Leverage-use of borrowed money to supplement existing funds for investment purposes (A leverage ratio of 20 means that for every dollar of capital that the bank owners have contributed, the bank has $20 of assets. Of the $20 of assets, are financed with borrowed money—either by taking in deposits or issuing debt.)  Capital requirement- purpose is to ensure banks will be able to pay off their depositors w/o resorting to govt 7. Tools of Monetary Control  Open Market Operations- buying or selling bonds ( INCREASE- buy bonds, DECREASE- sell bonds)  Discount Rate- used when banks borrow from Fed discount window and pay interest rate on the loan (HIGH discount rate= LOWER money supply, LOWER discount rate, HIGHER money supply)  Reserve Requirement- INCREASE= lower money supply, DECREASE=higher money supply) 8. Problems in Controlling the Money Supply  Fed doesn’t control money households choose to hold as deposits in banks  Fed doesn’t control amount bankers choose to lend Chapter 16: The Monetary System 9. Federal Funds Rate  Short term interest rate that banks charge one another for loans  Loans are temporary usually overnight  Price of the loan is the federal funds rate Chapter 17: Money Growth and Inflation 1. Velocity and the Quantity Equation  V=PY/M  V=velocity, P=price level, Y=quantity of output, M=quantity of money  Quantity Equation- relates quantity of money to nominal value of output, shows that increase in the quantity of money must be reflected in one of the other 3 variables  Quantity of output must rise, price level must rise, or velocity of money must fall  Velocity of money is normally stable  When there are changes in M, it causes proportionate changes in nominal value (PY)  Y is normally determined by labor, physical capital, human capital , tech. since money is neutral money doesn’t affect output  When central bank alters money supply, there are proportional changes in nominal value of output, and changes are reflected in the price level  When central bank increases the money supply rapidly, result is high rate of inflation 2. Inflation Tax  When govt raises revenue by printing money, price level rises, dollars in wallet are less valuable 3. The Fisher Effect  Real Interest Rate= Nominal Interest Rate- Inflation Rate  Nominal Interest rate= Real Interest rate+ Inflation Rate  Inflation does not in itself reduce people’s real purchasing power  Inflation can also raise nominal incomes  Shoeleather cost- cost of reducing money holdings (making more frequent trips to bank causes shoes to wear out more quickly) – sacrificing to keep less money on hand than you would if there was no inflation  Menu costs- costs of price adjustment, came from restaurant costs of printing out a new menu. Include costs of deciding new prices, printing new price lists and catalogs, sending new price lists to dealers and customers, ads for new prices  Market economies rely on relative prices to allocate resources  Inflation discourages saving through treatment of capital gains  Unintended changes in tax liabilities due to nonindexation of the tax code  Arbitrary redistributions of wealth between debtors and creditors  Many of the costs are large during hyperinflation Chapter 18- Open Economy Macro Basic Concepts 1. International Flows of Goods and Capital  Open economy interacts with others in two ways -buys and sells goods and services in world product markets -buys and sells capital assets like stocks/bonds in world markets2 2. Flow of Goods: Exports, Imports, Net Exports  Exports- domestically produced goods and services that are sold abroad  Imports- foreign produced goods and services that are sold domestically  Net Exports- Exports- Imports, aka trade balance  Trade surplus- exports > imports  Trade deficit- exports< imports  Balanced Trade- exports=imports, net exports =0  Factors that influence countrys exports, imports, net exports= tastes of consumers for domestic/foreign goods, prices of goods at home and abroad, exchange rates where people can use domestic currency to but foreign currencies, incomes, cost of transporting goods from country to country., govt policies toward intl trade. 3. Flow of Financial Resources: Net Capital Outflow  Net capital outflow: Purchase of foreign assets by domestic residents – Purchase of domestic assets  Can be positive or negative.  Positive NCO= domestic residents are buying more foreign assets than foreigners are buying domestic assets, capital is flowing OUT of the country  Negative NCO= domestic residents are buying less foreign assets than foreigners are buying domestic assets, capital is flowing INTO the country (capital inflow)  Variables that influence NCO- real interest rates paid on both foreign and domestic assets, perceived economic and political risks of holding assets abroad, govt policies that affect foreign ownership of domestic assets 4. Equality of Net Exports/ Net Capital Outflow  NCO=NX  NX> 0 = trade surplus  NX<0 = trade deficit 5. Saving, Investment, Relationship to Intl Flows  Y-C-G=I+NX  S=I+NX Chapter 18- Open Economy Macro Basic Concepts  S=I+NCO  Saving, investment, and intl capital flows are linked  S>I then NCO is positive, nation is using its saving to buy assets abroad  I>S then NCO is negative, which means foreigners are financing investment by purchasing domestic assets 6. The Prices for Intl Transactions: Real and Nominal Exchange Rate  Nominal Exchange Rate- rate at which the person can trade the currency of one country for the currency of another  Always express the nominal exchange rate as units of foreign currency per US dollar. Ex. 80 yen per dollar  Appreciation- exchange rate changes so dollar buys more foreign currency, strengthens  Depreciation- exchange rate changes so a dollar buys less foreign currency, weakens  Real exchange rate- rate at which a person can trade goods and services of one country for goods and services of another, expressed as units of the foreign item per unit of domestic item  Real exchange rate= Nominal exchange rate * Domestic price/Foreign Price  Real exchange rate is a key determinant of how much a country exports and imports 7. Purchasing Power Parity  Law of one price-Theory states that a unit of any given currency can buy same quantity of goods in all countries - US dollar must buy the same quantity of goods in the US and Japan and Japanese yen must buy same quantity of goods in Japan and US.  Arbitrage- process of taking advantage of price differences for the same item in different markets 8. Implications of Purchasing Power Parity  States that nominal exchange rate between currencies of two countries depends on price levels in those countries  1/P = e/P* which becomes 1=eP/P*  If the purchasing power of the dollar is always the same at home and abroad, then the real exchange rate- relative price of domestic and foreign goods cannot change  e= P*/P Chapter 18- Open Economy Macro Basic Concepts  Nominal exchange rate between the two countries must reflect price levels in those countries  Nominal exchange rate also depends on money demand and money supply in each country  When central bank in any country increases the money supply, causes price level to rise, causes currency to depreciate 9. Limitations of Purchasing Power Parity  Not completely accurate  Exchange rates do not always move to ensure that dollar has same real value in all countries the same  Many goods are not easily traded  Tradeable goods are not always perfect substitutes when produced in different countries and real exchange fluctuate Chapter 19- Supply and Demand for Loanable & Foreign Currency Exchange 1. Supply and Demand for LF and Foreign Currency Exchange  Loanable Funds- saving, investment, and flow of loanable funds abroad ( NCO)  Foreign Currency- people who want to exchange the domestic currency for other countries 2. Market for Loanable Funds  S=I +NCO  Domestically generated flow of resources available for capital accumulation  Higher interest rate encourages people to save, raises the quantity of loanable funds supplied and decreases quantity of loanable funds demanded  Higher real interest rate in US discourages americans from buying foreign assets and foreigners but US assets, US NCO decreases 3. Market for Foreign Currency Exchange  NCO=NX  Trade surplus – foreigners are buying more US goods/services than Americans ( NX>0)  Trade Deficit- Americans are spending more on foreign goods than they are earning from selling abroad (NX<0) 4. Net Capital Outflow- Link Between Two Markets  NCO links two markets  Loanable Funds- NCO is a piece of demand  Foreign Currency- NCO is source of supply  Key determinant- real interest rate 5. Equilibrium in Two Markets  Supply and Demand in loanable funds determines real interest rate  Real interest rate determines NCO which provides supply of dollars in market for foreign currency exchange  Supply and demand in foreign currency exchange market determine real exchange rate 6. Gov’t Budget Deficit  Reduces supply of loanable funds  Interest rates rises  NCO decreases  Reduce in supply of dollars in market for foreign currency exchange  Real exchange rate appreciates pushing toward a deficit 7. Trade Policy  Directly influences quantity of goods and services that a country imports or exports Chapter 19- Supply and Demand for Loanable & Foreign Currency Exchange  Common one is a tariff- tax on imported goods  Import quota-limit on quantity of a good produced abroad and sold domestically -increases the demand for dollars -causes real exchange rate to appreciate -net exports stay the same  Determine which curve shifts first- demand curve  Determine which way demand curve shifts  Compare new and old equilibria  Trade policies don’t affect trade balance bc they don’t alter national saving or investment  NX=NCO=S-I 8. Political Instability and Capital Flight  Capital Flight- large and sudden movement of funds out of a country  Increase in NCO increases demand for LF  Increases the interest rate ad NCO increases which leads to depreciation  Capital flight has largest impact on country from which capital is fleeing but also affects others


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